Banking: Core Concepts, Traps, and a Worked Example
What you must understand
Banking questions test the mechanics of how a bank earns money and manages risk. Anchor yourself in four ideas: the balance sheet (assets = liabilities + equity), the interest-rate spread (asset yield minus funding cost), credit risk (probability of default and loss given default), and liquidity (matching maturities of assets and liabilities). Know the distinction between a bank's capital (a cushion absorbing losses), its reserves (central-bank balances used for settlement), and its liquidity (ability to meet outflows). Candidates must also understand fractional reserve logic, deposit insurance, and the role of a central bank as lender of last resort.
Traps that appear in questions
- Confusing reserves with capital; a bank can hold ample reserves yet be insolvent.
- Mixing solvency (assets exceed liabilities) with liquidity (short-term cash needs).
- Assuming a higher spread always means higher profit, ignoring credit losses and operating costs.
- Treating duration and maturity as identical; duration measures price sensitivity to rate changes.
- Forgetting that deposit insurance protects depositors, not shareholders or bondholders.
Rule of thumb and worked example
Rule of thumb: Profit = (Interest income − Interest expense) − Expected credit losses − Operating costs. Always net out credit losses before judging profitability.
Worked example: A bank holds $500m of loans yielding 6% funded by $500m of deposits costing 2%. Gross spread income = (6% − 2%) × $500m = $20m. If expected credit losses are 1.5% of loans = $7.5m and operating costs are $6m, net profit = $20m − $7.5m − $6m = $6.5m. A naive candidate answering $20m falls into the classic trap.