Who among the world's population of authors would not love to write a timeless work? Ideally, a timeless work of fiction, but failing that, something factual that remains the undisputed benchmark for its subject. Somewhat paradoxically, I hold that the latter is actually harder to accomplish. Please don't get me wrong, only a very small minority of us (of which I am not one) have it in them to produce Hamlet, or Dune, or The Iliad, or The Assistant, or Crime and Punishment, or The Adventures of Sherlock Holmes, or The Crab With The Golden Claws, or Seven Pillars of Wisdom, or Peanuts, Featuring Good Ol' Charlie Brown, or countless other such immortal works. But once one has produced classic art, it lives forever. There is no need ever to update or modify it.

Practitioner textbooks, on the other hand, are rarely timeless. In almost every field of learning, society develops and adds to its knowledge base, such that a work of non‐fiction rapidly becomes out of date. To maintain currency requires constant updates and further editions, which means more work. An author ambitious of producing a literary masterpiece should avoid the factual learning genre.

But there is an apparent paradox when it comes to works of fact concerning banking: in theory, unlike in so many commercial disciplines, the main principles have not changed since the first modern banks came into being in the fifteenth century. Much of what held good for banks in 1808 and 1908 would have remained fine for banks in 2008, if certain senior bank executives had been competent enough to remember them (or even bothered to learn them in the first place).

The traditionally staid and “conservative” field of banking has experienced considerable development and change of late. However, if anything, this “development” has not been all positive. While lauding the introduction of tools and techniques that have enabled borrowers to reduce their risk and assist economic growth worldwide, most of us are now rightly wary of ever‐more sophistication and complexity in finance. It really is time for banks, and banking, to revert somewhat to the basics of finance and look to deliver genuine good customer service, and roll back the ever‐increasing complexity in the industry. Why? Because such sophistication often ended up doing more harm than good.

Finance is as much art as science anyway. So much of it is expectations based on assumptions, despite what the financial market “quants” would tell you. That this is not known universally is itself worrying, with bankers the world over convinced that the stated gross redemption yield of a bond purchased in the secondary market is actually what they will receive for holding said bond. The valuation of equities, the calculation of default probability, the expected life of a loan, the “risk weighting” of a loan asset, the “expected shortfall” risk exposure of a trading portfolio…these are all so much estimations based on assumptions. Which person in their right mind, trying to do the right thing for everyone, would wish to build sophistication on such a foundation?

In any case, in many countries banks have managed to transform their image from perceived bastions of stability and good social standing into seeming snake‐oil selling hucksters of low repute and lower intentions. This is a pity, because without banks performing their vital roles as secure stores of money and maturity transformation specialists, economic and social development would take place at a much slower pace. So while it is almost unarguable to state the importance of banks and the good they do for society, it is also unarguable to state that the work undertaken by banks must reflect sound risk management principles as well as scrupulous ethics and good intentions.

Hence, it becomes necessary to update the first edition of this “introductory” book about banking. The first edition isn't necessarily out of date, at least not all of it anyway – more that it doesn't emphasise the principles of banking as strongly as it should have. And of course it was never going to be timeless…works of fact so rarely are. But this second edition, requiring readers to shell out their hard‐earned cash for a second time, is needed so as to emphasise more of the principles of banking as well as update some of the technical content.

In any case, any author would do well to remember the words of Sir Arthur Conan Doyle from the preface to The Sherlock Holmes Stories (1903):

“…all forms of literature, however humble, are legitimate if the writer is satisfied that he has done them to the highest of his power. To take an analogy from a kindred art, the composer may range from the oratorio to the comic song and be ashamed of neither, so long as his work in each is as honest as he can make it. It is insincere work, scamped work, work which is consciously imitative, which a man should voluntarily suppress before time saves him the trouble.”

So that is the ultimate objective of this revised second edition: not to attempt to achieve timelessness and immortality, which would reflect only a monstrous and insufferable arrogance and egotism on my part, but rather simply to be viewed by readers as a work of honesty that was done to the best of the author's ability and that, if the market allows it, can remain of value on the bookshelf for many years to come. Irrespective of whether this last ambition is achieved, I hope at least that this book has served its purpose for today. And as Ian MacDonald so memorably said in the preface to his last update of the majestic Revolution In The Head, no further editions will be forthcoming.

LAYOUT OF THE BOOK

This book is comprised of 17 chapters, grouped in three parts. There is some rhyme and reason in the split: Part I may be considered a primer on the basics, not just of banking, but also the interest‐rate markets, customer service, and credit assessment – essentially, the basics of financial markets. Part II looks at the balance sheet in general, and asset–liability management in particular, while Part III covers strategy, regulatory capital, and operational risk.

For newcomers to the market there is a primer on financial market arithmetic in Appendix A at the back of the book.

New material in this second edition includes:

• Case studies on problem solving involving several real‐world risk management issues (and solutions) the author has been involved with;
• A chapter on liabilities strategy setting, as part of the balance sheet optimisation process;
• A detailed look at the importance of understanding net interest margin (NIM);
• Best‐practice ICAAP and ILAAP process principles;
• Various reasonably important sundries such as strategy and operational risk management.

As ever, the intention is to remain accessible and practical throughout, and to provide information of value to the practitioner in banking – we hope sincerely that this aim has been achieved. Comments on the text are welcome and should be sent to the author care of John Wiley & Sons Ltd, Chichester, England.

Banking is a long‐established and honourable profession. The provision of efficient loan and deposit facilities is an essential ingredient in human development and prosperity. For this reason, it is important that all banks are managed prudently. The art of banking remains unchanged from when banks were first established. At its core are the two principles of asset–liability mismatch and liquidity risk management. The act of undertaking loans and deposits creates the mismatch, because while investors like to lend for as short a term as possible, borrowers prefer to borrow for as long a term as possible. In other words, the act of banking is the process of maturity transformation, whereby banks “lend long” and “fund short”. Banks do not “match‐fund”, because there would never be enough funds available to match a 25‐year maturity mortgage with a 25‐year fixed deposit. Thus, banking gives rise to liquidity risk, and bankers are therefore required to take steps to ensure that liquidity, the ability to roll over funding of long‐dated loans, is continuously available.

We define banking as the provision of loans and deposits; the former produce interest income for the bank, while the latter create interest expense for the bank. On the bank's balance sheet the loan is the asset and the deposit is the liability, and the bank acts as the intermediary between borrowers and lenders. The fact that all banks, irrespective of their size, approach, or strategy, must manage the two basic principles of asset–liability management (ALM) and liquidity management means that they are ultimately identical institutions. They deal within the same markets and with each other. That means that the bankruptcy of any one bank, while serious for its customers and creditors, can have a bigger impact still on the wider economy because of the risk this poses to other banks. It is this systemic risk which posed the danger for the world's economies in 2008, after Lehman Brothers collapsed, and which remains a challenge for financial regulators.

This book introduces the fundamental art of banking, which is ALM and liquidity risk management. It does not describe the different types of banks and their organisational structures that exist around the world. Neither does it describe the wide range of bank products that are available or the great variation in financial markets and instruments that can be observed. These topics are covered abundantly in existing textbooks. The object of this book is to present bank ALM and liquidity management at an introductory level, something that is not so common in textbooks on finance. These topics deserve to be understood and appreciated by everyone involved in banking, because it was unsound practices in these fields that helped to create the banking crisis in 2008, and made its impact so much worse than it need have been. Proper respect for the art of ALM will mitigate the impact on banks of the next financial crash.