1. Banking Fundamentals

Before you build a liquidity engine, a payment hub or a ledger, you need a clear picture of what a bank is, how it makes money and where its risks come from. This chapter covers the bank business model, the parts of a bank balance sheet, the central bank framework that every bank works inside, and the ledger mechanics that every banking system ends up encoding. Later chapters on treasury, ALM, liquidity regulation and system architecture all assume these concepts.

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1.1 Role and Business Model of Banks

This subchapter explains why banks exist, how they turn that role into profit, and how the industry is split into business lines and group structures.

Financial Intermediation

Why it exists. In principle, people with spare money (savers) could lend it directly to people who need it (borrowers). In practice, direct lending rarely works at scale, for four reasons:

• Search costs: a household with EUR 5,000 has no practical way to find a company that needs EUR 5 million.
• Information asymmetry: borrowers know more about their own creditworthiness than lenders do. That leads to adverse selection (the riskiest borrowers are the keenest to borrow) and moral hazard (borrowers take more risk once they have the money).
• Diversification: a single saver cannot spread EUR 5,000 across 1,000 loans.
• Liquidity preference: savers want to get their money back at any time, while borrowers want funding for years.

What it is. A financial intermediary stands between savers and borrowers and takes the risk onto its own balance sheet. This is what separates a bank from a broker. A broker matches buyers and sellers and walks away. A bank borrows from savers (deposits are the bank's liabilities), lends to borrowers (loans are the bank's assets) and bears the credit loss if a borrower defaults. Depositors have a claim on the bank, not on the individual borrowers.

Analogy. A broker is like an estate agent: it introduces two parties and earns a commission. A bank is like a wholesaler: it buys inventory with its own money, stores it, and absorbs the loss if goods spoil.

How it works: the four transformations.

Transformation	Savers want	Borrowers want	How the bank bridges the gap
Size	To place small amounts	To borrow large amounts	Pools many small deposits
Maturity	Access on demand	Long-term funding	Relies on deposits being stable in aggregate (see next topic)
Risk	Safety of principal	Funding for risky projects	Screening, monitoring, diversification and an equity buffer
Liquidity	Claims they can use immediately	Funding for illiquid projects	Holds illiquid loans while issuing liquid deposits

Example.

   SAVERS                        BANK                          BORROWERS
   ------                        ----                          ---------
   Household A   5,000  --+                               +--> Mortgage     300,000
   Household B  12,000  --+--> Deposits      Loans    ----+--> SME loan     150,000
   Company C   400,000  --+    (liability)   (asset)      +--> Car loan      25,000

           <-- bank pays ~1.5% on deposits     bank earns ~6.0% on loans -->

   Savers have a claim on the BANK, not on the mortgage borrower.
   If the SME defaults, the bank takes the loss (first from its equity).

Key takeaways

• Banks exist because direct lending suffers from search costs, information asymmetry, lack of diversification and mismatched liquidity needs.
• A bank is a principal, not an agent: it borrows and lends on its own balance sheet and bears credit risk.
• The four transformations (size, maturity, risk, liquidity) are where the bank adds value, and also where its risks come from.

🧪 Practice

1. Beginner: For each of the four transformations, give a concrete example from your own banking relationship, such as your current account or a loan you have.
2. Intermediate: A peer-to-peer lending platform matches individual lenders with borrowers and charges a fee. Explain which of the four transformations it does and does not perform, and who bears the credit loss when a borrower defaults.
3. Interview: "Large corporates can issue bonds directly to investors. Why do banks still exist?" Hint: consider which borrowers can access bond markets, what information costs remain for small borrowers, and what deposits give savers that bonds do not.

Maturity Transformation

Why it exists. Depositors want instant access to their money. Borrowers want 25-year mortgages. If banks could only lend for as long as each depositor agreed to leave money in, long-term lending would barely exist. Maturity transformation resolves this: the bank funds long-term assets with short-term liabilities.

What it is. Contractually, a current account can be withdrawn tomorrow. Behaviorally, the total balance of a million current accounts is very stable: as some customers withdraw, others deposit. Banks rely on this law of large numbers to lend most of that money out long-term.

The bank is paid for this. Yield curves usually slope upward (long rates above short rates), so borrowing short and lending long earns a term premium. For example, the bank pays 1% on demand deposits and earns 4% on 10-year fixed-rate mortgages.

Analogy. A building's staircases are designed for normal traffic, not for every occupant leaving at the same moment. That works almost always. When everyone heads for the exit at once (a bank run), the design fails, however sound the building is.

The two risks it creates.

Risk	What goes wrong	Covered in
Liquidity risk	Depositors withdraw faster than assets can be turned into cash without losses	Chapter 5
Interest rate risk	Short-term funding reprices upward while long-term fixed-rate assets keep earning the old rate	Chapter 6

Example: a simplified contractual maturity ladder (in millions).

Time bucket	Assets maturing	Liabilities maturing	Gap (A - L)	Cumulative gap
Overnight to 1 month	50	400	-350	-350
1 month to 1 year	150	250	-100	-450
1 year to 5 years	300	200	+100	-350
Over 5 years	500	150 (incl. equity)	+350	0
Total	1,000	1,000

The cumulative gap is deeply negative in the short buckets. On paper, 450 million more is due to depositors within a year than the bank's assets will repay in that time. This is normal for a bank. It becomes dangerous only if depositors actually leave together, or if the bank cannot borrow or sell assets to cover the gap.

Key takeaways

• Maturity transformation (borrow short, lend long) is a core economic function of banks and a main source of their profit.
• It relies on deposits behaving more stably than their contractual terms suggest.
• It creates both liquidity risk (runs) and interest rate risk (repricing mismatch). Treasury exists largely to manage these two.
• A negative short-term gap is expected. What matters is how stable the funding is and how liquid the assets are.

🧪 Practice

1. Beginner: Using the ladder above, explain in your own words why the cumulative gap must end at zero in the last bucket.
2. Intermediate: A bank has 200 million of overnight deposits and 200 million of 10-year fixed-rate loans at 4%. Overnight rates rise from 1% to 4% and stay there. Describe what happens to the bank's annual net interest income and why.
3. Interview: "Silicon Valley Bank invested deposits in long-dated government bonds with almost no credit risk. How did it still fail?" Hint: combine interest rate risk on the bonds with the nature of its depositor base (concentrated, mostly uninsured, connected), and think about what happens when you must sell those bonds before maturity.

Net Interest Margin

Why it matters. For most commercial and retail banks, the largest source of revenue is the difference between what they earn on assets and what they pay on liabilities. Net interest margin (NIM) is the standard measure of how profitable that core business is, and treasury, ALM and FTP systems all exist partly to protect it.

What it is.

Net interest income (NII) = Interest income - Interest expense

NIM    = NII / Average interest-earning assets

Spread = Yield on earning assets - Cost of interest-bearing liabilities

NIM and spread are not the same. NIM benefits from free funding: equity and non-interest-bearing deposits fund assets without costing interest. This is why banks value current accounts so highly.

What drives NIM.

• Rate level and curve shape: a steeper curve generally helps maturity transformation.
• Deposit beta: the share of a policy rate change that the bank passes on to depositors. If the policy rate rises 100 bp and deposit rates rise 30 bp, the beta is 0.30. Low betas widen NIM when rates rise.
• Asset mix: unsecured consumer credit yields more than mortgages but carries more credit risk.
• Repricing profile: floating-rate assets reprice quickly, while fixed-rate mortgages reprice only at maturity or refinancing.
• Competition: for both loans and deposits.

Example (in millions, annual).

Average interest-earning assets          10,000   yield 5.00%  -> interest income   500.0
Average interest-bearing liabilities      8,500   cost  2.50%  -> interest expense  212.5
Free funding (equity + non-interest
  bearing deposits)                       1,500
                                                                  NII               287.5

Spread = 5.00% - 2.50%            = 2.500%
NIM    = 287.5 / 10,000           = 2.875%

The extra 0.375% of NIM over the spread comes from the 1,500 million of free funding.

Engineering note. NII looks like one subtraction, but producing it correctly needs daily accruals on millions of contracts, correct day count conventions (Chapter 11.1), back-valued corrections (Topic 1.4, Value Date vs Booking Date) and FTP allocation across business lines (Chapter 6.4).

Key takeaways

• NII = interest income - interest expense. NIM = NII / average interest-earning assets.
• NIM exceeds the spread when part of the assets is funded by equity or non-interest-bearing deposits.
• Deposit beta and repricing mismatch determine how NIM responds to rate changes.
• Small NIM changes have large profit effects: 10 bp on a 100 billion balance sheet is 100 million a year.

🧪 Practice

1. Beginner: A bank has average earning assets of 50 billion yielding 4.2% and interest-bearing liabilities of 44 billion costing 1.8%. Calculate NII, NIM and spread.
2. Intermediate: Rates rise by 200 bp. Of 10,000 million in earning assets, 40% are floating and reprice immediately; the rest are fixed for at least a year. All 8,500 million of interest-bearing liabilities reprice with a deposit beta of 0.30. Estimate the first-year change in NII and the new NIM, ignoring any change in balance sheet size or mix.
3. Interview: "Why might a bank's NIM fall even while the central bank is raising rates?" Hint: think about deposit betas rising over time, customers moving from current accounts to term deposits, fixed-rate assets, and an inverted yield curve.

Fee-Based Income

Why it matters. NII depends on the interest rate cycle and needs balance sheet capacity, which means capital and funding. Fee income diversifies revenue, tends to be more stable through rate cycles, and usually uses little capital. Investors therefore often value fee income more highly than NII.

What it is. Fee and commission income is revenue earned for providing services, not for lending money.

Category	Examples	Typical driver
Accounts and payments	Account maintenance, payment fees, overdraft fees	Number of customers and transactions
Cards	Interchange, annual fees, FX markups on card spend	Card volumes
Cash management	Cash pooling, payment factories, liquidity reporting (Chapter 10)	Corporate client mandates
Trade finance	Letters of credit, guarantees (Chapter 10.3)	Trade volumes
Asset and wealth management	Management fees as a percentage of AUM, performance fees	Assets under management
Custody and securities services	Safekeeping, settlement, corporate actions	Assets under custody
Investment banking	M&A advisory, bond and equity underwriting	Deal flow (volatile)
FX and markets	FX conversion margin for clients	Client flow

Trading income, from market making and position-taking, is usually reported separately from fees and is more volatile.

Example: simplified income statement (in millions).

Interest income                           5,000
Interest expense                         (2,100)
Net interest income                       2,900
Net fee and commission income             1,300
Net trading income                          400
------------------------------------------------
Total operating income                    4,600
Operating expenses                       (2,760)
Loan loss provisions                       (340)
------------------------------------------------
Profit before tax                         1,500

Fee share of income  = 1,300 / 4,600 = 28.3%
Cost-income ratio    = 2,760 / 4,600 = 60.0%

Engineering note. Fee engines are a common source of production incidents and customer complaints. Typical difficulties are tiered pricing, proration, waivers, minimum and maximum charges, rounding per currency and backdated tariff changes. In accounting, fees that are integral to a loan (such as arrangement fees) are spread over the loan's life as part of the effective interest rate under IFRS 9. Service fees are recognized when the service is delivered under IFRS 15. The same word "fee" can therefore need two different accounting treatments (Chapter 14.1).

Key takeaways

• Fee income is earned for services and depends less on interest rates and balance sheet size.
• It uses little capital, but carries operational and conduct risk (for example, mis-selling or unfair charges).
• The cost-income ratio (operating expenses / operating income) is a key efficiency metric.
• "Fee" does not always mean fee income in accounting: loan-related fees can be part of interest income.

🧪 Practice

1. Beginner: Classify each item as interest income, fee income or trading income: mortgage interest, card interchange, M&A advisory fee, gain on a bond sold from the trading book, monthly account fee, interest on a reverse repo.
2. Intermediate: Using the income statement above, recompute the cost-income ratio and profit before tax if fee income falls 20% and operating expenses fall 5%.
3. Interview: "Design a service that calculates monthly tiered account maintenance fees. What edge cases would you test?" Hint: tier boundaries (inclusive or exclusive), accounts opened or closed mid-month, tariff changes mid-period, waivers, rounding to currency minor units, and recalculation after back-valued transactions.

Retail vs Commercial vs Investment Banking

Why the split matters. "Banking" covers very different businesses with different clients, risks, revenue models and systems. Knowing which business line you are building for tells you what scale, latency, valuation complexity and regulation to expect.

What they are.

Dimension	Retail banking	Commercial (corporate) banking	Investment banking
Clients	Individuals, micro-businesses	SMEs, mid-caps, large corporates, public sector	Large corporates, financial institutions, governments, funds
Core products	Current and savings accounts, mortgages, consumer loans, cards	Working-capital and term loans, cash management, trade finance, FX hedging	Bond and equity underwriting, M&A advisory, sales and trading, prime brokerage
Main revenue	NII, account and card fees	NII, transaction and cash management fees	Advisory and underwriting fees, trading revenue
Dominant risks	Granular credit risk, conduct risk	Concentrated credit risk, counterparty risk	Market risk, counterparty risk, reputational risk
Transaction profile	Millions of small, simple transactions	Thousands of medium to large transactions	Fewer, very large, complex transactions
Typical systems	Core banking, card processing, digital channels	Loan origination, cash management portals, trade finance platforms	Trading platforms, pricing and risk engines, TMS

A note on terminology. In the US, "commercial bank" historically also meant a deposit-taking bank, as opposed to an investment bank. The Glass-Steagall Act (1933) separated the two until 1999. In Europe, "commercial banking" usually means the corporate client segment. Check which meaning a document uses.

Example: one company, three relationships.

                      Manufacturing company "Acme"
                                  |
     +----------------------------+------------------------------+
     |                            |                              |
 RETAIL                       COMMERCIAL                    INVESTMENT
 Acme's 2,000 employees       Acme's treasury:              Acme's CFO and board:
 - salary accounts            - revolving credit line       - issue a 500m bond
 - mortgages                  - cash pooling                - advice on acquiring
 - credit cards               - FX forwards for imports       a competitor
                              - letters of credit           - interest rate swap
                                                              to fix bond cost

Key takeaways

• Retail means high volume and standardized products. Commercial means relationship-based lending and transaction services. Investment banking means capital markets, advisory and trading.
• Each segment has a different risk profile, so its systems have different priorities.
• The same client often uses all three, which is a reason universal banks exist (next topic).

🧪 Practice

1. Beginner: Assign each product to a segment: SEPA instant payment for an individual, syndicated loan, IPO underwriting, notional cash pool, credit card, equity derivatives market making.
2. Intermediate: Explain why investment banking revenue is more volatile than retail banking revenue, using at least two drivers from the table.
3. Interview: "Which segment's systems need the highest transaction throughput, and which need the most complex valuation logic? How does that shape the architecture?" Hint: contrast retail payment and card volumes with derivatives pricing, and think about batch, streaming and grid compute.

Universal Banks and Bank Holding Companies

Why they exist. Combining retail, commercial and investment banking in one group creates economies of scope: shared clients, cross-selling, a cheap and stable deposit base that funds wholesale activities, and diversification across business cycles. The costs are complexity, conflicts of interest, and the risk that losses in risky activities endanger insured deposits. That last risk is the root of the "too big to fail" debate.

What they are.

• Universal bank: a single banking group offering the full range of services, often within the same legal entity. This is the traditional continental European model.
• Bank holding company (BHC): a parent company that owns one or more banks and often non-bank subsidiaries such as broker-dealers and asset managers. In the US, BHCs are supervised by the Federal Reserve. The parent typically issues equity and long-term debt and passes the funds down to its subsidiaries.

Structural rules that separate activities.

Rule	Jurisdiction	Effect
Volcker Rule	US	Restricts proprietary trading and fund investments by banking entities
Ring-fencing	UK (since 2019)	Large banks must hold core retail deposits in a separate ring-fenced bank
Intermediate holding company requirements	US, EU	Foreign banks above size thresholds must place local subsidiaries under a local holding company

Branch vs subsidiary. A branch is part of the same legal entity as its parent, so its assets and liabilities belong to the parent. A subsidiary is a separate legal entity with its own capital, liquidity requirements and regulator. The distinction decides where capital and liquidity can move freely.

Example: simplified group structure.

                   +----------------------------------+
                   |   Group holding company (BHC)    |
                   |   issues shares and HoldCo debt  |
                   +----------------+-----------------+
                                    |
         +--------------------------+----------------------------+
         |                          |                            |
+--------+---------+     +----------+----------+      +----------+---------+
| Bank subsidiary  |     | Broker-dealer /     |      | Asset management   |
| deposits, loans  |     | investment bank     |      | subsidiary         |
| own capital, LCR |     | trading, DCM, ECM   |      | funds, AUM         |
+--------+---------+     +---------------------+      +--------------------+
         |
+--------+---------+
| Foreign branch   |   <- same legal entity as the bank subsidiary
+------------------+

Why this matters for treasury and engineers. Liquidity and capital are measured and regulated per legal entity. Surplus cash in a subsidiary may be trapped: regulators or ring-fencing rules may stop it from being moved to the parent or a sister company. This is why intragroup funding (Chapter 7.1) and resolution planning (Chapter 7.3) exist. In practice, every position, trade and cash flow in a treasury system must carry a legal entity identifier.

Key takeaways

• Universal banks and BHCs combine business lines for economies of scope and stable funding.
• Structural rules (Volcker, ring-fencing) limit how risky activities can mix with insured deposits.
• Branches share their parent's legal entity; subsidiaries are separate, with their own capital and liquidity.
• Legal entity is a core dimension of every treasury data model.

🧪 Practice

1. Beginner: Draw the legal entity structure of a bank group you know (from its annual report), marking which units are subsidiaries and which are branches.
2. Intermediate: A group's bank subsidiary has 10 billion of surplus liquidity and its broker-dealer subsidiary needs 3 billion. List the reasons the transfer might be restricted, and how it could be done if allowed.
3. Interview: "Why must a treasury data model carry the legal entity on every position, and what goes wrong if it is only derived later from the booking desk?" Hint: think about per-entity regulatory reporting, trapped liquidity, intercompany eliminations on consolidation, and desks that book into more than one entity.

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1.2 Bank Balance Sheet Anatomy

The balance sheet is both a bank's inventory and its risk map; this subchapter walks through each part using one reference balance sheet.

Assets: Loans, Securities, Reserves

Why it matters. A bank's balance sheet looks inverted compared with an industrial company's. For a manufacturer, a bank loan is a liability and cash in the bank is an asset. For the bank, the same loan is an asset (a claim on the borrower) and the customer's cash is a liability (a deposit the bank owes back). The assets side shows where the bank has put its funding and how quickly it could turn those positions back into cash.

What it contains. Assets can be ranked by the trade-off between liquidity and yield:

 MORE LIQUID, LOWER YIELD                                      LESS LIQUID, HIGHER YIELD
 <---------------------------------------------------------------------------------->
 Central bank   Reverse repos,    Government    Covered and     Mortgages   SME and
 reserves       interbank         bonds         corporate                   consumer
                placements                      bonds                       loans

Asset class	What it is	Why the bank holds it
Cash and central bank reserves	Balances on the bank's account at the central bank	Settling payments, reserve requirements, liquidity buffer
Loans and advances to banks, reverse repos	Short-term lending to other banks, often secured by collateral	Investing short-term surplus cash
Securities	Government, covered and corporate bonds	Liquidity buffer (HQLA), interest income, collateral, hedging
Loans to customers	Mortgages, corporate loans, consumer credit	Core business and main source of interest income
Derivative assets	Derivatives with positive fair value	Hedging and client business
Other assets	Property, IT, goodwill, tax assets	Running the business

Accounting classification of securities. Securities are measured differently depending on the business model they are held under. Under IFRS 9:

• Amortized cost (hold to collect): price moves do not affect reported equity until the security is sold. This is broadly the US GAAP held to maturity (HTM) category.
• FVOCI (hold to collect and sell): fair value changes go to equity through other comprehensive income. This is broadly available for sale (AFS) in US GAAP.
• FVTPL (trading): fair value changes go through profit and loss.

Chapter 14.1 covers this in detail. For now, remember that unrealized losses on amortized-cost securities are not visible in reported equity, as the 2023 bank failures showed.

Example: the reference balance sheet (in billions) used in this subchapter.

ASSETS                                       LIABILITIES AND EQUITY
-------------------------------------------  -------------------------------------------
Cash and central bank reserves        80     Customer deposits                    620
Loans and advances to banks           40       - Retail sight deposits     300
Reverse repos                         30       - Retail term deposits      120
Securities                           180       - Corporate deposits        200
  - Amortized cost             110           Deposits from banks                   50
  - FVOCI                       50           Repos                                 40
  - FVTPL (trading)             20           Debt securities issued               120
Loans to customers (gross)           600     Derivative liabilities                35
  Allowance for credit losses        (12)    Subordinated debt                     25
Derivative assets                     40     Other liabilities                     20
Other assets                          42     Total liabilities                    910
                                             Equity                                90
-------------------------------------------  -------------------------------------------
TOTAL ASSETS                       1,000     TOTAL LIABILITIES AND EQUITY       1,000

In this example, loans make up 58.8% of assets (net 588 of 1,000). Cash and securities together are 26%.

Key takeaways

• For a bank, loans are assets and deposits are liabilities: the opposite of a customer's view.
• Assets range from highly liquid, low-yield reserves to illiquid, higher-yield loans. Asset allocation is a liquidity versus profitability trade-off.
• The accounting classification of securities decides whether price changes appear in P&L, in equity, or nowhere until sale.
• Loans are reported net of the allowance for expected credit losses.

🧪 Practice

1. Beginner: Using the reference balance sheet, calculate the share of total assets held as cash plus securities, and the share held as net customer loans.
2. Intermediate: Market rates rise and the 110 billion amortized-cost portfolio falls 8% in fair value. How much does reported equity change? How much would it change if the portfolio were classified as FVOCI? What happens if the bank has to sell the portfolio?
3. Interview: "A bank holds large excess reserves at the central bank earning the deposit facility rate. Why doesn't it simply lend them all to customers?" Hint: consider liquidity requirements and payment needs, and what happens to reserves in aggregate when one bank lends (see Topic 1.3, Money Creation by Commercial Banks).

Liabilities: Deposits, Borrowings, Debt Issuance

Why it matters. Liabilities are how a bank funds its assets. Funding sources differ in cost, in how quickly they can leave (stability), in maturity, and in what happens to them if the bank fails (seniority). Choosing and balancing these sources is a central treasury job (Chapter 7.1).

What it contains.

Funding source	Typical cost	Stability	Typical tenor	Secured?
Retail sight deposits (insured)	Very low	High	Overnight contractually; often years in practice	No (protected by deposit insurance)
Retail term deposits	Moderate	High until maturity	3 months to 5 years	No
Corporate operational deposits	Low to moderate	Medium	Overnight	No
Corporate and financial non-operational deposits	Close to market rates	Low	Overnight to 3 months	No
Interbank unsecured borrowing	Market rate plus credit spread	Low	Overnight to 1 year	No
Repo	Close to the risk-free rate	Medium; depends on collateral quality	Overnight to 1 year	Yes
Central bank operations	Policy rate	High while collateral is eligible	1 week to several years	Yes
Senior unsecured bonds	Higher	High (term funding)	2 to 10 years	No
Covered bonds	Low for term funding	High	3 to 20 years	Yes (cover pool of loans)
Subordinated debt (Tier 2)	High	High	10 years or more	No

Seniority: who gets paid first if the bank fails. The creditor hierarchy decides who absorbs losses in insolvency or resolution. It explains why subordinated debt costs more and why insured depositors are the least likely to lose money.

PAID FIRST
   ^   Secured creditors (repo, covered bonds), up to the value of their collateral
   |   Covered deposits (insured; claim transferred to the deposit guarantee scheme)
   |   Preferred deposits (individuals and SMEs above the insured amount)
   |   Senior preferred unsecured (ordinary senior bonds; other deposits in many regimes)
   |   Senior non-preferred
   |   Tier 2 subordinated debt
   |   Additional Tier 1 (AT1)
   v   Common equity (CET1)
ABSORBS LOSSES FIRST

(Simplified EU-style hierarchy; exact ranking varies by jurisdiction. See Chapter 7.3.)

Example. Using the reference balance sheet:

Customer deposits / total liabilities  = 620 / 910 = 68.1%
Loan-to-deposit ratio (net loans)      = 588 / 620 = 94.8%
Wholesale funding (banks + repos + debt issued + subordinated)
                                       = 50 + 40 + 120 + 25 = 235  (25.8% of liabilities)

A loan-to-deposit ratio below 100% means customer loans are fully funded by customer deposits. Banks well above 100% depend more on wholesale markets, which are more prone to sudden withdrawal.

Key takeaways

• Deposits are usually the cheapest and most stable funding, especially insured retail deposits.
• Wholesale funding is flexible but can disappear quickly in stress. Secured funding depends on collateral quality.
• Seniority determines cost: the more junior the instrument, the higher the return investors demand.
• The funding mix drives regulatory liquidity metrics (LCR, NSFR) and the bank's resilience.

🧪 Practice

1. Beginner: Rank these funding sources from most to least stable in a stress scenario and justify your ranking: insured retail deposits, overnight interbank borrowing, 5-year senior bond, corporate non-operational deposits, repo against government bonds.
2. Intermediate: A bank loses 100 in a resolution scenario. Using the hierarchy above and these holdings (CET1 60, AT1 10, Tier 2 25, senior non-preferred 40), show which classes absorb the loss and by how much.
3. Interview: "Why might a treasurer prefer expensive 5-year bond funding over cheap overnight interbank borrowing?" Hint: think about rollover risk, NSFR, rating agencies' view of funding stability, and what happens to overnight markets in a crisis.

Equity and Retained Earnings

Why it matters. Equity is the bank's first loss absorber. Assets minus liabilities equals equity, so every loss on an asset reduces equity one for one. Banks run with high leverage, which makes even small asset losses significant.

What it contains.

Component	What it is
Share capital and share premium	Money shareholders paid in when shares were issued
Retained earnings	Accumulated profits not paid out as dividends or buybacks
Accumulated other comprehensive income (OCI)	Unrealized gains and losses not in P&L, such as FVOCI securities or cash flow hedge reserves
Other reserves	Legal reserves, share-based payment reserves and similar
Treasury shares	Own shares bought back (deducted)

Accounting equity is not the same as regulatory capital. To compute CET1 (Chapter 7.2), regulators deduct items that cannot absorb losses in a crisis, such as goodwill, intangible assets and certain deferred tax assets.

Leverage. In the reference balance sheet, assets are 1,000 and equity is 90, so leverage is about 11x. A 9% loss on assets would wipe out all the equity. Profitability links to leverage through:

ROE = ROA x Leverage        where ROA = Net profit / Total assets
                                  Leverage = Total assets / Equity

Example: equity roll-forward for one year (in billions).

Opening equity                                   90.0
+ Net profit                                     10.0
- Dividends paid                                 (4.0)
- Share buyback                                  (2.0)
+ OCI: fair value loss on FVOCI securities       (1.0)
-------------------------------------------------------
Closing equity                                   93.0

ROA  = 10 / 1,000                 = 1.0%
ROE  = 10 / average(90, 93) = 10 / 91.5   = 10.9%

Retained earnings rose by 10 - 4 = 6. The buyback reduced equity through treasury shares, and the FVOCI loss reduced accumulated OCI without touching profit.

Key takeaways

• Equity = assets - liabilities. It is the residual claim and absorbs losses first.
• Retained earnings grow with profit and shrink with dividends. OCI captures unrealized gains and losses outside P&L.
• Banks are highly leveraged (often 10 to 20x), so small percentage losses on assets cause large percentage losses on equity.
• Regulatory capital starts from accounting equity but applies deductions and adjustments.

🧪 Practice

1. Beginner: Opening equity is 50, net profit 6, dividends 2.5, and a cash flow hedge reserve gain of 0.5 is recorded in OCI. Calculate closing equity and the change in retained earnings.
2. Intermediate: Starting from the reference balance sheet, the bank's assets lose 3% of their value. Calculate the new equity, the new leverage ratio (assets / equity), and the percentage loss to shareholders.
3. Interview: "Why do banks operate with much higher leverage than industrial companies, and what limits it?" Hint: deposits are both the bank's product and its funding, deposit insurance, risk-weighted capital ratios, and the non-risk-based leverage ratio (Chapter 7.2).

Off-Balance-Sheet Exposures

Why it matters. Some of a bank's most important risks do not appear on its balance sheet. A promise to lend, or a guarantee of a client's obligations, creates no asset or liability today, but can turn into one suddenly, often in a crisis when many clients need cash at once. The 2007 to 2008 crisis was partly caused by off-balance-sheet vehicles that banks had to take back onto their balance sheets.

What it is.

Item	What it is	Becomes on-balance-sheet when	Main risks
Undrawn committed credit line	Promise to lend up to a limit	The client draws on it	Credit, liquidity
Financial guarantee, standby letter of credit	Promise to pay if the client fails to	The guarantee is called	Credit, liquidity
Documentary letter of credit	Payment undertaking in international trade	Compliant documents are presented	Credit, operational
Derivative notional	Reference amount of a derivative contract	Never; only the fair value is recognized	Market, counterparty
Securities lending as agent	Lending client securities on their behalf	An indemnity given to the client is triggered	Counterparty
Assets under custody or management	Assets owned by clients	Normally never	Operational, reputational

How regulators capture it. Basel capital rules convert off-balance-sheet items into on-balance-sheet equivalents using credit conversion factors (CCFs): the expected share of the commitment that will be drawn before a default. Liquidity rules (LCR, Chapter 9.2) assume stressed drawdown rates on committed facilities.

Example: a revolving credit facility.

Corporate client has a 100m committed revolving credit facility (RCF)

Normal times:                           Stress (client draws 60m more):
+------------------------------+        +------------------------------+
| Drawn:     20m  (on BS loan) |        | Drawn:     80m  (on BS loan) |
| Undrawn:   80m  (off BS)     |  --->  | Undrawn:   20m  (off BS)     |
+------------------------------+        +------------------------------+
                                         Bank must fund 60m of cash TODAY.

Credit exposure with a 40% CCF on the undrawn amount:
   20m drawn + 40% x 80m undrawn = 52m exposure equivalent

In March 2020, corporates drew heavily on their credit lines at the same time, so off-balance-sheet commitments became on-balance-sheet funding needs within days.

Derivatives show a similar gap: an interest rate swap with a notional of 500m and a fair value of +3m appears on the balance sheet as a 3m derivative asset. The 500m is disclosed in the notes but does not appear on the balance sheet.

Key takeaways

• Off-balance-sheet items are contingent: they can turn into assets and liabilities, often in stress.
• Undrawn commitments are a key source of contingent liquidity risk (Chapter 5.1).
• Capital rules use credit conversion factors. Liquidity rules apply stressed drawdown assumptions.
• Client assets in custody or under management are not the bank's assets, but they bring operational risk.

🧪 Practice

1. Beginner: A bank has issued 30m of financial guarantees with a 100% CCF and has 200m of undrawn credit lines with a 40% CCF. Calculate the total credit exposure equivalent.
2. Intermediate: Explain why assets under custody do not appear on a custodian bank's balance sheet, and what legal principle protects clients if the custodian fails.
3. Interview: "How would you model a committed credit line so that both the credit risk engine and the liquidity engine can use it?" Hint: separate limit, drawn and undrawn amounts; availability period; cancellability; and behavioral drawdown assumptions per client segment and scenario.

Reading a Bank's Annual Report

Why it matters. A listed bank's annual report, with its Pillar 3 disclosures, is the most complete public picture of its business model, risks and controls. For an engineer it also shows what your systems eventually produce: almost every number in it comes from a ledger, a risk engine or a reporting pipeline.

What it contains.

• Strategic or management report: strategy, key metrics, segment performance, outlook.
• Financial statements: balance sheet, income statement, statement of comprehensive income, statement of changes in equity, cash flow statement.
• Notes to the financial statements: accounting policies, fair value hierarchy, maturity analysis, credit loss allowances, hedge accounting, related parties.
• Risk report and Pillar 3 disclosures: capital, leverage, liquidity (LCR, NSFR), interest rate risk in the banking book (IRRBB), credit, market and operational risk.

Where to find what.

Question	Where to look
How big is the bank and how is it funded?	Balance sheet; notes on deposits and debt issued
How profitable is it, and from what?	Income statement; notes on NII and fees; segment reporting
How much loss-absorbing capacity does it have?	Capital section of the risk report; Pillar 3 (CET1 ratio, leverage ratio)
How liquid is it?	Liquidity risk section; Pillar 3 (LCR, NSFR); contractual maturity note
How exposed is it to interest rates?	IRRBB disclosure (NII and EVE sensitivity); fair value of amortized-cost securities
How good are the loans?	Credit risk note: IFRS 9 stages 1, 2 and 3, NPL ratio, coverage
How are instruments valued?	Fair value hierarchy note (Level 1, 2, 3)

Key ratios.

Ratio	Formula	What it tells you
NIM	NII / average interest-earning assets	Core lending profitability
Cost-income	Operating expenses / operating income	Efficiency (lower is better)
ROE	Net profit / average equity	Return to shareholders
CET1 ratio	CET1 capital / risk-weighted assets	Solvency buffer
LCR	HQLA / stressed 30-day net cash outflows	Short-term liquidity (minimum 100%)
NSFR	Available stable funding / required stable funding	Structural funding (minimum 100%)
Loan-to-deposit	Customer loans / customer deposits	Reliance on wholesale funding
NPL ratio	Non-performing loans / gross loans	Asset quality

Example: a 30-minute reading path.

1. Key figures page        -> size, profit, CET1, LCR at a glance
2. Balance sheet           -> asset mix, funding mix, equity
3. NII and fees notes      -> what drives revenue
4. Segment reporting       -> which business lines earn and lose money
5. Liquidity and IRRBB     -> LCR, NSFR, maturity gaps, rate sensitivity
6. Fair value note         -> Level 3 assets, unrealized losses on amortized-cost securities
7. Auditor's report        -> key audit matters (areas of judgment and risk)

Common pitfalls.

• Comparability: US GAAP allows derivatives to be netted under master netting agreements far more readily than IFRS does. US banks' balance sheets can look much smaller than European peers' for the same activity.
• Alternative performance measures: "adjusted" or "underlying" profit excludes items management considers one-off. Always reconcile to reported figures.
• Restatements: prior-year numbers may be restated. Compare against the restated figures.

Key takeaways

• Annual reports combine financial statements, notes and risk and Pillar 3 disclosures. The notes and risk sections often matter most.
• A small set of ratios (NIM, cost-income, CET1, LCR, NSFR, loan-to-deposit) summarizes most of a bank's profile.
• Accounting differences (IFRS vs US GAAP) can distort comparisons between banks.
• Every disclosed number comes from systems; data lineage and controls (Chapter 9.3) are what make it trustworthy.

🧪 Practice

1. Beginner: Pick a listed bank and find, from its latest annual report or Pillar 3 disclosure: total assets, CET1 ratio, LCR, NSFR and cost-income ratio.
2. Intermediate: Compare the loan-to-deposit ratio and the share of fee income of two banks with different business models (for example, a retail-focused bank and an investment-bank-heavy group). Explain the differences.
3. Interview: "Given only a bank's annual report, how would you assess its exposure to a sharp rise in interest rates?" Hint: look at IRRBB disclosures (EVE and NII sensitivity), the gap between fair value and carrying value of amortized-cost securities, the deposit mix, and the fixed-rate share of the loan book.

<a id="13-central-banks-and-the-monetary-system"></a>

1.3 Central Banks and the Monetary System

Central banks set the price and quantity of the money that all banks settle in; this subchapter explains the framework every bank treasury operates inside.

Central Bank Mandates

Why central banks exist. Money only works if people trust it to keep its value and if payments between banks are final. History has many examples of unstable private currencies, banking panics and inflation. Central banks were created, or took on new powers, to provide a trusted monetary anchor and to act as a backstop for the banking system.

What they do. Most modern central banks combine several functions:

• Monetary policy: steering short-term interest rates, and sometimes long-term rates, to meet an inflation target and, for some central banks, an employment objective.
• Financial stability: monitoring systemic risk, setting macroprudential policy and acting as lender of last resort to solvent but illiquid banks.
• Payment system operation: running the real-time gross settlement (RTGS) system where banks settle with each other in central bank money (Chapter 2.2).
• Banking supervision: in many jurisdictions, licensing and supervising banks.
• Issuing banknotes and managing the state's reserves.

Most are operationally independent: governments set the goal, and the central bank decides how to reach it without political interference. The reasoning is that politicians have an incentive to stimulate the economy before elections at the cost of future inflation.

Comparison of three major central banks.

	ECB (Eurosystem)	Federal Reserve	Bank of England
Primary mandate	Price stability: 2% inflation over the medium term, symmetric	Maximum employment and stable prices (2% PCE inflation)	Price stability: 2% CPI inflation, set in the government's remit
Financial stability role	Macroprudential tasks; directly supervises significant banks through the Single Supervisory Mechanism (SSM)	Supervises bank holding companies; financial stability monitoring	Financial Policy Committee; the PRA supervises banks
Key policy rate	Deposit facility rate	Federal funds target range	Bank Rate
RTGS system	T2	Fedwire Funds Service	RTGS (settles CHAPS)

Example: the monetary policy transmission chain.

Central bank changes policy rate
        |
        v
Overnight interbank rates move (EUR: euro short-term rate (€STR), USD: SOFR / fed funds, GBP: SONIA)
        |
        v
Banks' funding costs change ---> treasury reprices FTP curves (Chapter 6.4)
        |
        v
Loan and deposit rates change for customers
        |
        v
Borrowing, saving, investment and asset prices respond
        |
        v
Demand, employment and inflation adjust (with lags of 1 to 2 years)

Key takeaways

• Central banks provide price stability, financial stability, payment infrastructure and often banking supervision.
• Mandates differ: the ECB and BoE put price stability first; the Fed has a dual mandate.
• Policy decisions reach the real economy through banks, so bank treasuries are the first link in the transmission chain.
• For engineers, the central bank is also an operational counterparty: it runs the RTGS, holds the bank's reserve account and publishes collateral eligibility rules.

🧪 Practice

1. Beginner: Identify the central bank for a currency you work with, its inflation target, and the name of its main policy rate.
2. Intermediate: Explain why operational independence is thought to lower long-term inflation expectations, and what might happen to long-term bond yields if markets doubted it.
3. Interview: "Which central bank functions directly affect a bank's treasury systems on a daily basis?" Hint: RTGS operating hours and cut-offs, reserve account balances, standing facilities, collateral eligibility lists and haircuts, and published reference rates.

Reserve Requirements

Why they exist. Historically, reserve requirements forced banks to hold a minimum share of their deposits as cash or central bank balances. The aims were to ensure banks could meet withdrawals and to give central banks control over the money supply. Today their role is narrower. Where they still exist, they mainly stabilize demand for central bank reserves so the central bank can steer short-term rates more precisely. Several central banks have abolished them.

How they work.

Required reserves = Reserve ratio x Reserve base (eligible liabilities)

• The reserve base is usually short-term liabilities such as deposits and short-term debt. Liabilities to other banks subject to the same regime are usually excluded.
• The requirement is met on average over a maintenance period, not every day. This averaging lets banks absorb daily payment shocks: they can run balances below the requirement one day and above it the next.
• Remuneration varies. Reserves may be paid interest or not.

Jurisdiction	Current approach
Eurozone	1% on liabilities with maturity up to 2 years; met on average over a maintenance period; minimum reserves remunerated at 0% since September 2023
United States	Requirement reduced to 0% in March 2020; banks still hold large voluntary reserves
United Kingdom	No reserve requirement; banks choose their reserve targets and reserves are remunerated at Bank Rate

Example: averaging over a 5-day maintenance period (simplified; real periods last several weeks).

Reserve base 50,000m x 1% = 500m required average

Day        1      2      3      4      5     | Average
Balance  300    800    200    700    500     |   500   -> requirement met

On days 1 and 3 the balance was well below 500m, but the average meets the requirement. That flexibility acts as a liquidity buffer for intraday and day-to-day payment flows.

Key takeaways

• Reserve requirements oblige banks to hold a minimum average balance at the central bank against eligible liabilities.
• Averaging over the maintenance period makes the requirement a flexible buffer, not a hard daily floor.
• Many central banks now run with abundant reserves, which makes requirements less relevant or removes them.
• Treasury systems must track daily reserve balances against the running average to avoid end-of-period shortfalls.

🧪 Practice

1. Beginner: A bank's reserve base is 80 billion and the ratio is 1%. What is its required reserve average?
2. Intermediate: In a 10-day maintenance period with a 500m requirement, the bank's average balance over the first 7 days was 450m. What average balance does it need over the last 3 days to meet the requirement?
3. Interview: "If US reserve requirements are 0%, why do US banks still hold trillions of dollars in reserves?" Hint: consider the ample-reserves regime, interest on reserve balances, LCR treatment of reserves as HQLA, and intraday payment needs.

Policy Rates and Corridors

Why it matters. Central banks cannot set every interest rate in the economy, but they can anchor the shortest one, the overnight rate at which banks lend reserves to each other. Every other rate, from treasury bills to mortgages, builds on that anchor. A treasury system needs to know which official rates exist and which one actually drives market rates.

How the corridor works. A central bank typically offers two standing facilities that banks can use at their own initiative:

• A lending facility (ECB: marginal lending facility) where banks can borrow overnight against collateral at a high rate. This sets the ceiling: no bank will pay more in the market than it can pay the central bank.
• A deposit facility (ECB: deposit facility rate) where banks can deposit surplus reserves overnight. This sets the floor: no bank will lend to another bank for less than the central bank pays.

Arbitrage keeps the overnight market rate inside this band. Where in the band it trades depends on how plentiful reserves are.

Example: an illustrative euro area corridor (rates are examples, not current values).

Rate
 ^
 |  --------------------------------------  Marginal lending facility (ceiling)   2.40%
 |
 |
 |  --------------------------------------  Main refinancing operations rate      2.15%
 |
 |  --------------------------------------  Deposit facility rate (floor)         2.00%
 |  ~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~  Euro short-term rate (€STR)           ~1.92%
 +-------------------------------------------------------------------------> time

With abundant reserves, the market rate falls to the floor. The €STR can trade slightly below the deposit facility rate because some lenders in the market (such as money market funds) do not have access to the deposit facility and accept slightly less from banks that do.

Corridor vs floor systems.

	Corridor system	Floor system
Reserves	Scarce; the central bank supplies roughly what banks need	Abundant (excess reserves)
Where the market rate trades	Near the middle of the corridor	Near the floor
Effective steering rate	Main refinancing or target rate	Deposit rate or interest on reserves
Central bank operations	Frequent fine-tuning of reserve supply	Few; mainly sets the administered rate
Examples	Euro area before 2008	Fed since 2008, euro area since about 2015, Bank of England

In the US, the Fed sets a 25 bp target range for the federal funds rate. It keeps the rate in the range mainly by setting the interest rate on reserve balances (IORB) and an overnight reverse repo (ON RRP) facility for non-banks, which acts as a sub-floor.

Key takeaways

• Standing facilities create a ceiling (lending rate) and a floor (deposit rate) for overnight market rates.
• In a floor system with abundant reserves, the deposit rate or interest on reserves is the effective policy rate.
• Overnight benchmarks (€STR, SOFR, SONIA) can trade slightly away from official rates because of market structure.
• "The central bank rate" is ambiguous: always specify which rate and its effective date.

🧪 Practice

1. Beginner: Explain why the overnight interbank rate cannot rise above the lending facility rate for a bank that has eligible collateral.
2. Intermediate: A bank has 1 billion in surplus reserves. Compare the overnight income from (a) leaving it at the deposit facility at 2.00% and (b) lending it to another bank at €STR of 1.92%, both on an ACT/360 basis. Why might a bank still lend in the market?
3. Interview: "Your system stores 'the ECB rate' as a single field. What could go wrong?" Hint: there are three official rates, rates change on specific effective dates, contracts reference different rates (deposit remuneration vs refinancing cost), and history is needed for recalculations.

Open Market Operations

Why they exist. To keep market rates where it wants them, a central bank must manage the quantity of reserves in the system. Reserves move for reasons outside its control: government tax receipts and spending, demand for banknotes, foreign exchange flows. Open market operations (OMOs) are the tools the central bank uses to add or drain reserves.

What they are.

Instrument	Effect on reserves	Duration
Repo (central bank lends cash against collateral, e.g. ECB main refinancing operations)	Adds reserves	Temporary
Reverse repo or fixed-term deposit (central bank absorbs cash)	Drains reserves	Temporary
Outright purchase of securities	Adds reserves	Permanent
Outright sale of securities	Drains reserves	Permanent
FX swap	Adds or drains	Temporary
Central bank debt certificates	Drains reserves	Temporary

Key mechanics.

• Collateral: central bank credit is always secured. Each central bank publishes a list of eligible assets.
• Haircuts: the collateral's value is reduced by a percentage to protect the central bank. Bonds with a market value of 100 and a 5% haircut support 95 of borrowing.
• Tender procedures: the central bank can offer a fixed amount at a variable rate (banks bid) or lend a full amount at a fixed rate (fixed-rate full allotment, used by the ECB since 2008).

Example: a one-week central bank repo, in T-accounts.

Bank borrows 100 for one week against government bonds (market value 105, ~5% haircut)

COMMERCIAL BANK                               CENTRAL BANK
Assets            | Liabilities                Assets               | Liabilities
------------------+---------------------       ---------------------+--------------------
+100 reserves     | +100 repo payable          +100 claim on bank   | +100 reserves of bank
(bonds 105 stay on|      to central bank       (secured by bonds)   |
 BS, now encumbered)

One week later: the bank repays 100 plus interest, reserves fall back,
and the bonds are released.

The bonds stay on the bank's balance sheet because the bank still owns the risk and return, but they are now encumbered: they cannot be sold or pledged elsewhere until the repo matures (Chapter 5.4).

Key takeaways

• OMOs add or drain reserves to keep short-term rates in line with policy.
• Temporary operations (repos) are secured by collateral with haircuts. Outright operations change reserves permanently.
• Central bank funding creates future cash outflows and encumbers collateral. Both must be reflected in liquidity and collateral systems.
• Collateral eligibility and haircut tables are critical reference data for treasury.

🧪 Practice

1. Beginner: Draw the T-accounts for the maturity of the repo in the example, including 0.04 of interest.
2. Intermediate: A bank holds bonds with a market value of 400m. The central bank applies a 2% haircut to 300m of them and a 12% haircut to the rest. How much can the bank borrow? What happens to that capacity if the bonds fall 5% in price?
3. Interview: "How does a central bank repo show up in a bank's liquidity forecast and collateral management system?" Hint: the cash inflow today, the outflow at maturity, which collateral is encumbered, collateral substitution, and margin calls if collateral values fall.

Quantitative Easing and Tightening

Why they exist. When the policy rate is already close to its effective lower bound (around 0%, or slightly negative), the central bank cannot cut further to stimulate the economy. Quantitative easing (QE) instead works on long-term rates and the quantity of money: the central bank buys large amounts of longer-dated bonds, pushing their prices up and their yields down. Quantitative tightening (QT) reverses this.

What QE does.

• Lowers long-term yields by removing duration from the market and compressing the term premium.
• Portfolio rebalancing: investors who sold bonds move into riskier assets, supporting asset prices.
• Signaling: shows that the central bank intends to keep rates low for longer.
• Increases reserves and deposits: when the central bank buys a bond from a non-bank investor, both bank reserves and customer deposits rise.

Major programs include the Fed's large-scale asset purchases (2008 to 2014, 2020 to 2022), the ECB's APP (from 2015) and PEPP (from 2020), and the Bank of England's Asset Purchase Facility (from 2009).

What QT does. The central bank lets bonds mature without reinvesting the proceeds (passive run-off), or sells them (active sales, used by the Bank of England from 2022). Reserves and deposits shrink. If reserves fall too far, money market stress can follow, as in the US repo rate spike of September 2019.

Example: QE purchase in T-accounts. The central bank buys 100 of government bonds from a pension fund, which banks with a commercial bank.

CENTRAL BANK               COMMERCIAL BANK                PENSION FUND
A: +100 gov bonds          A: +100 reserves               A: -100 gov bonds
L: +100 reserves           L: +100 deposit (pension fund) A: +100 bank deposit
   (owed to bank)

Both reserves (base money) and deposits (broad money) rose by 100, without the commercial bank lending anything. This is why banks' deposits surged in 2020 to 2021.

Effects on banks.

Phase	Effects on banks
QE	Deposit inflows; large excess reserves; low long-term yields compress NIM; banks buy securities to invest surplus deposits
QT and rate hikes	Deposit outflows; reserves fall; unrealized losses on securities bought at low yields; competition for deposits rises

Key takeaways

• QE is large-scale asset buying to lower long-term rates once policy rates hit their lower bound. QT reverses it.
• QE mechanically increases both central bank reserves and commercial bank deposits.
• QE-era deposits and low-yield securities created the interest rate and liquidity vulnerabilities exposed in 2022 to 2023.
• Treasury must model how deposit volumes respond to QE and QT, not just to policy rates.

🧪 Practice

1. Beginner: Using T-accounts, show what happens when the pension fund in the example later buys a newly issued government bond from the government during QT, assuming the government holds its account at the central bank.
2. Intermediate: Explain why a bank's deposits can grow strongly during QE even if it makes no new loans, and why those deposits may be less stable than traditional retail deposits.
3. Interview: "Connect QE, deposit growth, securities portfolios and the 2023 US regional bank failures in a few steps." Hint: deposit surge, investment in long-dated fixed-rate securities, rapid rate hikes, unrealized losses on amortized-cost securities, flighty uninsured deposits, forced sales.

Money Creation by Commercial Banks

Why it matters. The textbook "money multiplier" says banks collect deposits first and then lend a fraction of them out. This is misleading. Most money in a modern economy is bank deposits, and banks create those deposits when they lend. Understanding this changes how you read a bank's balance sheet, and it matches how a core banking system actually books a loan.

What actually happens. When a bank makes a loan, it does not hand over someone else's deposit. It credits the borrower's account with a new deposit. Both sides of the bank's balance sheet expand at the same moment. The Bank of England's 2014 article "Money creation in the modern economy" is the standard reference for this.

• Loans create deposits: a new loan creates a matching new deposit.
• Repayments destroy deposits: repaying a loan reduces both the deposit and the loan.
• Reserves are a separate layer: reserves are balances at the central bank and only move between banks and the central bank. Banks do not "lend out reserves" to customers. Reserves are used to settle payments between banks.

What limits money creation. Not the amount of reserves, but:

• Demand for credit from creditworthy borrowers.
• Profitability: the loan must earn more than the cost of funding, capital and expected losses.
• Capital requirements: every loan consumes capital (Chapter 7.2).
• Liquidity: when borrowers spend the new deposit, it usually moves to another bank, and the lending bank must settle in reserves. It needs to attract deposits or borrow to replace them.
• Monetary policy: the central bank influences the price of reserves and therefore of lending.

Example: a loan and its settlement, in T-accounts.

Step 1: Bank A lends 200 to customer X

BANK A
Assets                  | Liabilities
------------------------+--------------------------
+200 loan to X          | +200 deposit of X           <- new money created

Step 2: X pays 200 to supplier Y, who banks at Bank B

BANK A                                     BANK B
Assets           | Liabilities             Assets           | Liabilities
-----------------+---------------------    -----------------+-------------------
-200 reserves    | -200 deposit of X       +200 reserves    | +200 deposit of Y

Bank A now holds a 200 loan funded by 200 fewer reserves.
Its treasury must replace that liquidity: attract deposits, borrow
interbank or in repo, or borrow from the central bank.

In a core banking system, step 1 is literally a two-sided posting: debit the loan account, credit the customer's current account. No pre-existing deposit is "used up".

Key takeaways

• Bank lending creates new deposits, which are new money. Loan repayment destroys them.
• Reserves are a separate, central-bank-level asset used to settle payments between banks. They are not lent to customers.
• Lending is limited by demand, profitability, capital, liquidity and monetary policy, not by a fixed multiplier.
• Treasury's job after a loan is funding the liquidity outflow when the new deposit leaves the bank.

🧪 Practice

1. Beginner: Draw the T-accounts when customer X repays 50 of the loan from their deposit at Bank A.
2. Intermediate: Explain why the statement "banks lend out their customers' deposits" is misleading, and identify the one situation where it is approximately true from a single bank's point of view.
3. Interview: "If loans create deposits, what actually limits how much a bank can lend?" Hint: list capital, liquidity, profitability and credit demand constraints, and explain which one usually binds first for a fast-growing bank.

<a id="14-core-banking-concepts-for-engineers"></a>

1.4 Core Banking Concepts for Engineers

These are the mechanics every banking system encodes; getting them wrong produces errors in money that are silent until reconciliation or audit finds them.

Accounts and Ledgers

Why they exist. A bank must be able to prove, at any moment and for any past moment, who owns what and how that came about. Regulators, auditors, customers and courts all rely on this record. A database row that says "balance: 1,000" cannot answer "why?" or "what was it last Tuesday?".

What they are.

• Account: a named container for value, with an owner, a currency, a product type and a status. It is the address that entries are posted to.
• Entry (posting): a single movement of an amount to or from one account, with direction (debit or credit), dates and a reference to the transaction it belongs to.
• Ledger: the complete, append-only collection of entries. An account's balance is derived from its entries.

Banks distinguish:

Account kind	Examples	Owner
Customer accounts	Current account, savings account, loan account	A customer
Internal (technical) accounts	Suspense, clearing, transit, fee income accounts	The bank
Nostro accounts	The bank's accounts held at other banks or the central bank	The bank (Chapter 2.1)
General ledger accounts	Aggregated accounting accounts used for financial statements	The bank (topic below)

Immutability. Posted entries are never edited or deleted. Mistakes are corrected with reversal entries (an equal and opposite posting) followed by a new correct entry. This preserves a full audit trail.

Analogy. A ledger is like a git history and the balance is like the working tree. You can always rebuild the current state by replaying the history, and you never rewrite history that others rely on. You add a new commit to fix it.

Example: minimal data model.

accounts
  account_id | owner_id | currency | product      | status | opened_on
  ACC-001    | CUST-77  | EUR      | CURRENT      | OPEN   | 2024-01-10
  ACC-900    | BANK     | EUR      | FEE_INCOME   | OPEN   | 2020-01-01

entries
  entry_id | txn_id | account_id | direction | amount  | currency | booking_date | value_date
  E-1      | T-10   | ACC-001    | CREDIT    | 1000.00 | EUR      | 2025-03-03   | 2025-03-03
  E-2      | T-11   | ACC-001    | DEBIT     |    5.00 | EUR      | 2025-03-31   | 2025-03-31
  E-3      | T-11   | ACC-900    | CREDIT    |    5.00 | EUR      | 2025-03-31   | 2025-03-31

Balance(ACC-001) = credits - debits = 1000.00 - 5.00 = 995.00   (customer liability view)

At scale, banks store periodic balance snapshots (for example end of day) so that a balance can be computed as the snapshot plus later entries, instead of summing billions of rows.

Key takeaways

• Accounts are addresses; entries are movements; balances are derived from entries.
• The ledger is append-only. Corrections are made with reversals, never updates or deletes.
• Banks run customer, internal, nostro and general ledger accounts, and all must reconcile.
• Snapshots make balance queries fast without giving up the entry history as the source of truth.

🧪 Practice

1. Beginner: Extend the data model above with the fields you would need to support account closure, account holds and multiple owners.
2. Intermediate: Explain the risks of storing only a mutable balance column updated in place, with no entry history. Describe two failure scenarios involving concurrency or partial failure.
3. Interview: "How would you compute an account's balance as of any past date efficiently, on a ledger with billions of entries?" Hint: periodic snapshots plus deltas, partitioning by account and date, and how back-valued entries invalidate snapshots (bitemporal modeling, Chapter 13.2).

Double-Entry Bookkeeping

Why it exists. If money is recorded in only one place, errors and fraud are hard to detect: a value can appear or disappear without trace. Double-entry bookkeeping, formalized in 15th-century Italy, requires every transaction to be recorded in at least two accounts, with total debits equal to total credits. Money is never created or destroyed in the books. It is always moved from somewhere to somewhere.

What it is. The rule follows from the accounting equation:

Assets = Liabilities + Equity

(and, during a period, Equity changes with Income - Expenses)

Every transaction keeps this equation balanced. In ledger terms:

• A journal entry describes a transaction as a set of legs (debits and credits).
• For each transaction, in each currency: sum of debits = sum of credits.
• Transactions can have more than two legs, such as a payment with a fee and tax.

Analogy. Think of conservation of mass in a chemical reaction: atoms rearrange but the totals on both sides of the equation must match. A posting that does not balance is like a reaction that creates matter: it signals an error.

Example 1: customer sends a 1,000 EUR outgoing payment (from the bank's point of view).

Transaction T-1001
  Dr  Customer current account (liability, decreases)     1,000.00 EUR
  Cr  Settlement account at central bank (asset, decreases) 1,000.00 EUR
                                                         -------------
                                       Debits = Credits = 1,000.00 EUR

Example 2: customer converts 1,000 EUR to USD at 1.1000. Each currency must balance on its own, so the bank uses FX position accounts.

Transaction T-1002
  Dr  Customer EUR account       1,000.00 EUR
  Cr  FX position EUR            1,000.00 EUR     <- EUR legs balance
  Dr  FX position USD            1,100.00 USD
  Cr  Customer USD account       1,100.00 USD     <- USD legs balance

The FX position accounts now show the bank is long 1,000 EUR and short 1,100 USD, an open FX position the FX desk must manage (Chapter 8.2).

Example 3: the invariant in code.

from collections import defaultdict
from decimal import Decimal

def validate_balanced(legs):
    totals = defaultdict(lambda: Decimal("0"))
    for leg in legs:
        sign = 1 if leg.direction == "DEBIT" else -1
        totals[leg.currency] += sign * leg.amount
    unbalanced = {ccy: t for ccy, t in totals.items() if t != 0}
    if unbalanced:
        raise ValueError(f"Unbalanced transaction: {unbalanced}")

Posting all legs of a transaction must also be atomic: either every leg is written or none is.

Key takeaways

• Every transaction has debits equal to credits, per currency, which keeps Assets = Liabilities + Equity.
• Multi-currency transactions balance through FX position accounts, not across currencies.
• Validate the balancing invariant before posting, and post all legs atomically.
• An imbalance in the ledger always means a defect, never a rounding detail to ignore.

🧪 Practice

1. Beginner: Write the journal entry for a bank disbursing a 50,000 EUR loan into a customer's current account.
2. Intermediate: Write the journal entries for a month-end accrual of 120.50 EUR of interest owed to a depositor (not yet paid), and for its payment into the customer's account on the first of the next month.
3. Interview: "At end of day, your ledger's total debits exceed total credits by 0.01 EUR. How would you investigate?" Hint: look for FX legs rounded independently, multi-leg transactions written non-atomically, retries that posted only some legs, and fee calculations rounded at a different stage than the principal.

Debits, Credits and Balances

Why it is confusing. On your bank statement, a "credit" increases your balance. In accounting, a debit increases an asset. Both are correct because they take different perspectives: your deposit is your asset but the bank's liability, and statements are written from the bank's books. Engineers who mix up the perspectives produce sign bugs.

The rules. Debit and credit do not mean "plus" and "minus". Their effect depends on the account type:

Account type	Debit	Credit	Normal balance
Asset (loans, reserves, securities)	Increase	Decrease	Debit
Liability (deposits, debt issued)	Decrease	Increase	Credit
Equity	Decrease	Increase	Credit
Income	Decrease	Increase	Credit
Expense	Increase	Decrease	Debit

Mnemonic: DEA-LER. Dividends, Expenses and Assets increase with a debit. Liabilities, Equity and Revenue increase with a credit.

Perspective flip. When a customer deposits 100 in cash:

Bank's books:        Dr Cash (asset +100)        Cr Customer deposit (liability +100)
Customer statement:  "Your account was credited with 100"   <- bank's liability view
Customer's own books: Dr Bank account (their asset +100)    Cr Cash (their asset -100)

Balance types. One account can have several valid "balances":

Balance	Definition	Used for
Ledger (booked) balance	Sum of all posted entries	Statements, accounting
Value-dated balance	Sum of entries with value date on or before date D	Interest calculation, liquidity
Available balance	Ledger balance - holds - uncleared funds + overdraft limit	Authorizing payments and withdrawals
Projected (forward) balance	Includes entries with future value dates	Cash positioning (Chapter 5.2)

Example: computing the available balance.

Ledger balance                         5,000.00
- Card authorization hold                (200.00)
- Uncleared cheque deposit (in ledger)   (300.00)
+ Approved overdraft limit             1,000.00
------------------------------------------------
Available balance                      5,500.00

Sign convention in systems. You must choose one representation and enforce it everywhere:

• Signed amounts (for example debit positive, credit negative): sums are easy, but readers must know the convention, and liability balances show as negative.
• Absolute amount plus direction indicator: clearer and matches messaging standards. ISO 20022 uses a positive amount with a CdtDbtInd of CRDT or DBIT (Chapter 12.2). Every aggregation must apply the indicator.

Key takeaways

• Debits increase assets and expenses; credits increase liabilities, equity and income.
• Bank statements use the bank's perspective: a credit to your account increases the bank's liability to you.
• "Balance" is ambiguous. Always specify ledger, value-dated, available or projected.
• Pick one sign convention, document it, and convert explicitly at system boundaries.

🧪 Practice

1. Beginner: For each event, state which account is debited and which is credited in the bank's books: a customer withdraws cash; the bank pays its staff salaries from its central bank account; a borrower pays loan interest from their current account.
2. Intermediate: An account has a ledger balance of 2,400, holds of 650, an incoming payment with a value date of tomorrow of 1,000 (already booked), and no overdraft. What are the available balance today and the projected balance tomorrow? State your assumptions.
3. Interview: "Signed amounts versus a debit/credit indicator in a ledger schema: which would you choose, and why?" Hint: weigh aggregation simplicity, readability, interoperability with ISO 20022 and SWIFT, normal-balance sign flips in reports, and the risk of double negation bugs.

Value Date vs Booking Date

Why two dates exist. The moment a transaction is recorded is not always the moment it becomes effective. A correction may be recorded today but should count from last week. An FX trade agreed today settles in two business days. Interest, availability and liquidity depend on when money is effective, while accounting and audit depend on when it was recorded.

What they are.

Date	Meaning	Drives
Trade date	When the deal was agreed (for trades)	P&L recognition, risk positions
Booking date (posting date)	When the entry was recorded in the ledger	Statements, accounting period, audit trail
Value date	When the funds are effective for interest and availability	Interest calculation, liquidity, cash positioning

Value dates can be:

• Equal to the booking date: most domestic payments.
• In the future (forward-valued): FX spot trades settle two business days after the trade date for most currency pairs. Securities settle T+1 or T+2 (Chapter 2.3).
• In the past (back-valued): corrections, late-arriving payments, interest adjustments.

In the EU, the Payment Services Directive restricts how banks set value dates for customer payments. Broadly, a payee's account must be credited with a value date no later than the business day the bank receives the funds, and a payer's account cannot be debited with a value date earlier than the day the funds are debited.

Example: a back-valued correction and its interest effect.

Day       1 Mar      2 Mar      3 Mar      4 Mar      5 Mar
                                ^                     ^
                                |                     |
                          value date             booking date
                          (effective)            (recorded)

A 10,000 EUR deposit that arrived on 3 Mar was misrouted to suspense and
only booked to the customer's account on 5 Mar, with value date 3 Mar.

Interest for 3 Mar and 4 Mar at 3.00% ACT/360:
  10,000 x 0.03 x 2 / 360 = 1.67 EUR

The interest engine must recompute accruals for 3 and 4 Mar,
even though those days are already closed.

Example: balances by the two dates.

Entry	Amount	Booking date	Value date
Opening balance	5,000	28 Feb	28 Feb
Correction (above)	+10,000	5 Mar	3 Mar
FX sale settling spot	-2,000	4 Mar	6 Mar

Balance as of 4 Mar, by booking date: 5,000 - 2,000          = 3,000
Balance as of 4 Mar, by value date:   5,000 + 10,000         = 15,000
   (but on 4 Mar the system did not yet KNOW about the 10,000:
    "as known on 4 Mar" vs "as known on 5 Mar" is a bitemporal question)

Key takeaways

• The booking date is when something is recorded; the value date is when it is effective. Trades also have a trade date.
• Interest and liquidity use value dates. Statements and accounting periods use booking dates.
• Back-valued entries force recalculation of interest and other date-dependent results, including on closed days.
• Supporting "balance as of date X, as known on date Y" requires bitemporal data (Chapter 13.2).

🧪 Practice

1. Beginner: For an FX spot trade agreed on Monday 2 June 2025 (no holidays), state the trade date, the likely booking date and the value date.
2. Intermediate: Using the balances table above, compute the value-dated balance on each day from 1 March to 6 March, and explain which interest calculation each day would use.
3. Interview: "You are designing a balance service. Which dates must every entry carry, and which queries need which date?" Hint: customer statements, interest accrual, intraday liquidity, regulatory reporting as of a past date, and reproducing a report exactly as it was originally produced.

Business Days and Cut-Off Times

Why they exist. Payment and settlement systems do not run continuously. Large-value systems open and close at fixed times, observe holidays, and require instructions before specific deadlines. A payment instructed one minute after the cut-off may settle a day later, or several days later around holidays. For a bank that means missed obligations, overdraft charges, penalty interest or failed trades. Instant payment schemes (Chapter 2.2) run 24/7, but most treasury flows still follow business-day calendars.

What they are.

• Business day: a day when the relevant system or market is open. Each currency and market has its own holiday calendar. For example, the TARGET calendar for euro settlement observes 1 January, Good Friday, Easter Monday, 1 May, 25 December and 26 December.
• Joint calendar: for transactions involving two currencies (such as FX), the value date must be a business day in both currencies' calendars (Chapter 11.1).
• Cut-off time: the latest time an instruction can be submitted for same-day processing. Cut-offs are layered:
  • Scheme cut-offs, set by the system operator. For example, T2 has an earlier cut-off for customer payments (17:00 CET) than for interbank payments (18:00 CET). Fedwire Funds has a customer transfer cut-off of 18:00 ET and closes at 19:00 ET.
  • Internal bank cut-offs, set earlier than scheme cut-offs to leave time for checks, sanctions screening and processing.
  • Client cut-offs, published to customers, earlier still.

Always confirm current times in the scheme's operational documentation; they change.

Time zones matter. Cut-offs are defined in the scheme's local time, including daylight saving changes. A system running in UTC must convert explicitly.

Example: computing the execution date for a euro customer payment.

Internal cut-off for TARGET customer payments: 16:30 CET

Instructed                  Business day?         Before cut-off?   Execution date
Tue 15 Apr 2025 10:00 CET   yes                   yes               Tue 15 Apr
Tue 15 Apr 2025 16:45 CET   yes                   no                Wed 16 Apr
Thu 17 Apr 2025 17:00 CET   yes                   no                Tue 22 Apr  (*)
Sat 19 Apr 2025 09:00 CET   no (weekend)          n/a               Tue 22 Apr  (*)

(*) Fri 18 Apr 2025 is Good Friday and Mon 21 Apr 2025 is Easter Monday:
    both are TARGET holidays.

def execution_date(instructed_at, calendar, cutoff_time, tz):
    local = instructed_at.astimezone(tz)
    d = local.date()
    if calendar.is_business_day(d) and local.time() < cutoff_time:
        return d
    return calendar.next_business_day_after(d)

A typical bank day (illustrative).

 07:00          09:00                      16:30            18:00        19:00
   |--------------|---------------------------|----------------|------------|
   RTGS opens     Peak payment flows;         Internal         Interbank    End-of-day:
   (settlement    treasury funds positions    customer         cut-off      reserve balance
   of overnight                               cut-off                       final; standing
   queues)                                                                  facilities

Key takeaways

• Business days are calendar- and currency-specific. Cross-currency transactions need joint calendars.
• Cut-offs are layered: scheme, then internal, then client, each earlier than the last.
• Cut-off checks must use the scheme's time zone and handle daylight saving correctly.
• Holiday calendars are critical reference data: they must be versioned, sourced reliably and updated before holidays are announced or changed.

🧪 Practice

1. Beginner: Using the TARGET holidays above and a 16:30 CET internal cut-off, compute the execution date for euro payments instructed at: Wed 24 Dec 2025 15:00, Wed 24 Dec 2025 17:00, and Wed 31 Dec 2025 16:00.
2. Intermediate: An EUR/USD spot trade is agreed on a day when T+2 falls on a US holiday that is a TARGET business day. Explain how the value date is determined and why both calendars matter.
3. Interview: "A payment batch job starts at 16:25 and takes 10 minutes; the internal cut-off is 16:30. What design flaws does this reveal, and how would you fix them?" Hint: where the cut-off is checked (submission vs acceptance), partial batches, buffers, monitoring and alerting against cut-offs, and what should happen to payments that miss it.

Chart of Accounts and General Ledger

Why they exist. A bank has millions of customer accounts and many specialized systems: loans, deposits, payments, treasury. To produce financial statements and regulatory reports, all of this activity must be summarized into a consistent, controlled set of accounting categories. The chart of accounts defines those categories, and the general ledger holds the summarized balances.

What they are.

• Chart of accounts (CoA): the structured list of general ledger accounts, each with a code, name, type (asset, liability, equity, income, expense) and position in a hierarchy that rolls up to financial statement lines.
• General ledger (GL): the bank's master accounting record, containing balances per GL account. It is the source of the financial statements.
• Subledgers: detailed ledgers in operational systems (loan system, deposit system, TMS, payments hub). They hold the contract- and account-level detail and send aggregated journals to the GL.
• Accounting rules engine: translates business events (loan disbursed, interest accrued, trade settled) into GL postings according to configured rules.

GL postings usually carry more than an account code. They carry a set of segments, for example:

ENTITY - ACCOUNT - COST CENTER - PRODUCT - CURRENCY
IT01   - 130100  - CC4500      - MORTG   - EUR

Example: chart of accounts excerpt.

Code	Name	Type	Statement line
110100	Cash at central bank	Asset	Cash and central bank balances
130100	Loans to customers: mortgages	Asset	Loans to customers
130900	Accrued interest receivable: loans	Asset	Loans to customers
210100	Retail sight deposits	Liability	Customer deposits
410100	Interest income: mortgages	Income	Interest income
510100	Interest expense: retail deposits	Expense	Interest expense

Example: posting rule and flow.

Event: LOAN_INTEREST_ACCRUED (product = MORTG, amount = 1,234.56 EUR)
Rule:  Dr 130900 Accrued interest receivable: loans
       Cr 410100 Interest income: mortgages

  Loans subledger -------+
  Deposits subledger ----+
  Treasury system (TMS) -+--> Accounting rules engine --> General ledger --> Financial statements,
  Payments hub ----------+    (event -> posting rules)     (by segment)       COREP / FINREP
                                       |
                                       +--> Suspense account for unmapped or rejected events

Reconciliation. The total of each subledger must agree with the corresponding GL accounts (Chapter 13.4). Differences come from timing, unmapped events, manual GL adjustments and FX revaluation.

Key takeaways

• The chart of accounts defines the accounting categories; the general ledger holds the summarized balances behind the financial statements.
• Subledgers keep the detail and send aggregated postings to the GL through rules-based mapping.
• GL postings carry segments (entity, account, cost center, product, currency) that let one GL serve many reporting views.
• Subledger to GL reconciliation is a core control; unmapped events should land in suspense accounts, never silently drop.

🧪 Practice

1. Beginner: Using the CoA excerpt, write GL postings for: a mortgage disbursement of 200,000 EUR paid out through the central bank account, and monthly interest of 45.00 EUR accrued on retail sight deposits.
2. Intermediate: Explain why the GL normally holds aggregated balances instead of every customer transaction, and what that means for drill-down and audit requirements.
3. Interview: "At month-end, the mortgage subledger total differs from the GL by 1.2 million EUR. How would you approach it?" Hint: compare by segment and date to isolate the break, then check for cut-off timing differences, events without posting rules, entries stuck in suspense, manual GL adjustments, and FX revaluation differences.

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