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Chapter One

An Overview of the
Changing Financial-
Services Sector

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Key Topics

• Powerful Forces Reshaping the Industry


• What Is a Bank?
• The Financial System and Competing
Financial-Service Institutions
• Old and New Services Offered to the Public
• Key Trends Affecting All Financial-Service
Firms

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The Different Kinds of Financial Service


Firms Calling Themselves Banks
• Commercial Banks • Limited Purpose Banks
• Savings Banks • Bankers’ Banks
• Cooperative Banks • Minority Banks
• Mortgage Banks • National Banks
• Community Banks • State Banks
• Money Center Banks • Insured Banks
• Investment Banks • Member Banks
• Merchant Banks • Affiliated Banks
• International Banks • Virtual Banks
• Wholesale Banks • Fringe Banks
• Retail Banks • Universal Banks

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The Financial Service Competitors of Banks


• Savings Associations
• Credit Unions
• Money Market Funds
• Mutual Funds (Investment Companies)
• Hedge Funds
• Security Brokers and Dealers
• Investment Banks
• Finance Companies
• Financial Holding Companies
• Life and Property-Casualty Insurance Companies

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Quick Quiz
• What is a bank? How does a bank differ
from most other financial-service
providers?

• Under current U.S. federal law what must a


corporation do to qualify and be regulated
as a commercial bank?

• What is happening to banking’s share of the


financial marketplace and why?
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Traditional Services Offered By Banks

• Carrying Out Currency Exchange


• Discounting Commercial Notes and Making
Business Loans
• Offering Savings Deposits
• Safekeeping of Valuables
• Supporting Government Activities with
Credit
• Offering Checking Accounts
• Offering Trust Services
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More Recent Services Offered by


Banks
• Granting Consumer Loans
• Providing Financial Advice
• Managing Cash
• Offering Equipment Leasing
• Making Venture Capital Loans
• Selling Insurance Policies
• Selling Retirement Plans

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Offering Security Brokerage and


Investment Banking Services

• Underwriting Securities
• Offering Mutual Funds and Annuities
• Offering Merchant Banking Services
• Offering Risk Management and Hedging
Services

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Trends Affecting Banks and Other


Financial Service Firms Today
• Service Proliferation
• Rising Competition
• Government Deregulation
• Increased Interest Rate Sensitivity
• Technological Change and Automation
• Consolidation and Geographic Expansion
• E-Banking and E-Commerce
• Convergence
• Globalization
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Quick Quiz

• Why do banks and other financial


intermediaries exist in modern society,
according to the theory of finance?

• How have banking and the financial services


market changed in recent years?

• What powerful forces are shaping financial


markets and institutions today? Which of
these forces do you think will continue into
the future?
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Web Links

• Federal Deposit Insurance Company www.fdic.gov


• Federal Financial Institutions Examination Council
www.ffiec.gov
• Office of Thrift Supervision www.ots.treas.gov
• Credit Union National Association www.cuna.org
• Morningstar, Inc. http://www.morningstar.com
• Security and Exchange Commission www.sec.gov
• Careers in Finance www.careers-in-finance.com
• Bank Job Search www.bankjobsearch.com
• Bank Jobs www.bankjobs.com

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Chapter Three
The Organization and
Structure of Banking
and the Financial-
Services Industry

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Key Topics

• The Organization and Structure of the


Commercial Banking Industry
• The Array of Organizational Structures in
Banking
• Interstate Banking and the Riegle-Neal Act
• The Financial Holding Company
• Mergers and Acquisition
• Banking Structure and Organization in Europe
and Asia
• The Changing Organization and Structure of
Banking’s Principal Competitors
• Economies of Scale and Scope
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Assets Held by U.S. FDIC-Insured


Commercial Banks, 2007
2%

11%
Assets Held By Large
Banks
Assets Held By Medium
Banks
Assets Held By Small Banks
87%

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Number of U.S. FDIC-insured


Commercial Banks, 2007

7%

43% Small ≤ $100 Million

50% Medium $100 Million -


$1 Billion
Large > $1 Billion

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Community Banks or Retail Banks


• ‘Typical’ Size is $300 Million
• Organizational Chart is Not Complicated
• Significantly Affected by Health of Local
Economy
• Generally Know their Customers Well –
Relationship Lending

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Money Center or Wholesale Banks

• Generally Multi-Billion Dollar Company


• Organizational Chart is Much More Complex
• Serve Many Different Markets with Many
Different Services so are Better Diversified
Geographically and by Product
• Able to Raise Large Amounts of Capital at
Relatively Low Costs

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Quick Quiz
• What are the general trends in the size
distribution and asset concentration of
American banking industry?
• Describe differences between a typical
organizational structure of smaller
community bank and a larger money-center
bank.
• What trends are affecting the way banks
and their competitors are organized today?

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Common Classifications of U.S. Banks


FDI C I ns ur ed B ank s 98%

Not FDI C I ns ur ed 2%

0% 20% 40% 60% 80% 100% 120%

Nat i onal B anks 25%

St at e B anks 75%

0% 10% 20% 30% 40% 50% 60% 70% 80%

M ember B anks 36%

Non M ember B anks 64%

0% 10% 20% 30% 40% 50% 60% 70%

Source: FRB and FDIC, 2005


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Deposits Held By Banks


Deposi t s of Nat i onal B anks 55%

Deposi t s of St at e B anks 45%

0% 10% 20% 30% 40% 50% 60%

Deposi t s of M ember B anks 77%

Deposi t s of Non M ember B anks 23%

0% 10% 20% 30% 40% 50% 60% 70% 80% 90%

Source: FRB and FDIC, 2005


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Unit Banks

• Offer All Services From One Office


• One of the Oldest Kinds of Banks
• New Banks are Generally Unit Banks Until
Can Grow and Attract More Resources

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Branch Banks
• Offer Full Range of Services from Several
Locations
• Senior Management at the Home Office
• Each Branch has its Own Management Team
with Limited Decision Making Ability
• Some Functions are Highly Centralized,
While Others are Decentralized

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Reasons for Growth of Branching

• Exodus of Population to Suburban


Communities
• Increased Bank Failures in Recent Years
• Business Growth

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What Trend in Branch Banking Has Been


Prominent in the U.S. in Recent Years?
Year # of Bank # of Total of Ave # of
Main Branch U.S. Bank Branches/
Offices Offices Offices U.S. Bank

1934 14,146 2,985 17,131 0.21

1970 13,511 21,810 35,321 1.61

1982 14,451 39,784 54,235 1.75

2007 7,241 77,947 85,188 10.76

From Table 3-2; Source: FDIC


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Electronic Branches
• Internet Banking Services
• Automated Teller Machines (ATMs)
• Point of Sale (POS) Terminals

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Virtual Banks

• Provide their Services Exclusively Through


the Web
• Can Generate Cost Savings Over Traditional
Brick-and-Mortar Banks
• Have Not Yet Demonstrated They Can Be
Consistently Profitable

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Bank Holding Companies (BHC)

• A Corporation Chartered for the Purpose of


Holding the Stock of One or More Banks
• Control of a bank is Assumed When 25% or
More of the Stock is Owned
• Must Get Approval from Federal Reserve
Board to Control a Bank
• One-Bank Holding Companies vs. Multibank
Holding Companies

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Organizational Structure of a BHC


Single Bank Holding Company

Board of Directors

Parent Company

Each subsidiary has a


Bank Subsidiary Nonbank Subsidiaries
president and line officers

Bank Branches

The bottom four levels have the same organizational form as the independent bank.

Multibank Holding Company

Board of Directors

Parent Company

Bank Subsidiary Nonbank Subsidiaries Bank Subsidiary

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Bank Branches Bank Branches
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Nonbank Businesses of BHCs


• Finance Companies • Investment Banking
• Mortgage Companies Firms
• Data Processing • Trust Companies
Companies • Credit Card
• Factoring Companies Companies
• Security Brokerage • Leasing Companies
Firms • Insurance Companies
• Financial Advising and Agencies
• Credit Insurance • Real Estate Services
Underwriters • Savings Associations
• Merchant Banking
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Reasons for the Growth of BHCs

• Geographic Diversification
• Product Line Diversification
• Tax Sheltering
• Double Leveraging
• Source of Strength
• A Way Around Regulatory Restrictions

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Reasons for Full-Service Interstate


Banking
• Need to Bring New Capital to Revive
Struggling Local Economies
• The Expansion by Non Bank Financial
Institutions with Fewer Restrictions
• A Strong Desire by Large Banks to Expand
Geographically
• Belief Among Regulators that Large Banks
are More Efficient and Less Prone to Failure
• Advances in Technology

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Riegle-Neal Interstate Banking and


Branching Efficiency Act of 1994
• Allows BHCs to Acquire Banks Anywhere in
the U.S.
• Allows BHCs to Convert Banks to Branches –
June 1997
• States Can ‘Opt Out’ and Not Allow BHCs to
Convert to Branches
• States Can ‘Opt In’ Early
• Limits Deposits of One BHC to 10%
Nationwide and 30% Within One State

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Proponents and Opponents of


Interstate Banking

Proponents Opponents
• Efficient Use of Scarce • Increased Bank
Resources Concentration
• Lower Prices for Services • Less Competition
• Geographic Diversification • Higher Prices for Services
• Efficient Flow of Credit in • Drain Resources from
the System Community

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Financial Holding Companies: GLB


Act of 1999
• Special Type of Holding Company
• Offers the Broadest Range of Services
• List of Activities Offered May Expand as
Regulators Decide What Services are
‘Compatible’ with Banking
• Each Affiliated Financial Firm has its Own
Capital and Management and its Own Profit
or Loss

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Sample Organizational Structure of FHC

Financial Holding
Company

Bank Securities Real


Insurance Thrift Holding
Subsidiaries
Holding Subsidiary Company Estate
Company Subsidiary

Subsidiaries
Commercial Nonbank Thrift Company and Service
Banking Subsidiaries Companies
Company

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Bank Subsidiaries

• Bank Controls One or More Subsidiaries


• Subsidiaries Offer Other Services Such as
Insurance and Security Brokerage Services
• Profits and Losses of Each Subsidiary Impact
Parent Bank

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The Changing Organization and


Structure
• Rise in Branching, BHCs, and FHCs
• Consolidation among Banks and Nonbanks
• Convergence
• Other forces of change:
▫ Deregulation/Reregulation
▫ Financial Innovation
▫ Securitization
▫ Globalization
▫ Advances in Technology
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Do Bigger Firms Operate at Lower


Cost?
• Economies of Scale
• Exhibit 3-10
• Economies of Scope
• Banking and Financial Firm Goals and
Motivations
• Expense-Preference Behavior
• Agency Theory
• Corporate Governance

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Structure and Organization of


Banks in Europe
• Germany – Largest European Banking
Industry
▫ Private Sector Banks
▫ Public Sector Banks
• France – Second in Number of Banks
• Belgium – Dominated by Five Large Banks
• Great Britain – Dominated by a Half Dozen
Banking Firms
• Switzerland – Credit Suisse and UBS and
Many Smaller Firms
• Italy Privatized Banking in the 1990’s
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Structure and Organization of


Banks in Asia
• China – Large Dominating Government
Sector, Although Private Banks are
Expanding
• Japan – Dominated by the Big Four Financial
Group with More than One Hundred Smaller
Domestic Banks and Seventy Foreign Banks

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Quick Quiz
• Which type of corporations chartered for the
simple purpose of holding the stock of at least
one bank?
• What were the reasons for the Riegle Neal Act
of1994?
• When the banking industry moves toward
larger but fewer organizations, what is it
known as?
• What relationship appears to exist between
bank size, efficiency, and operating costs per
unit of service produced and delivered?
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Chapter Five
The Financial
Statements of Banks
and Their Principal
Competitors

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Key Topics
• An Overview of the Balance Sheets and Income
Statements of Banks and Other Financial Firms
• The Balance Sheet or Report of Condition
• Asset Items
• Liability Items
• Recent Expansion of Off-Balance Sheet Items
• The Problem of Book-Value Accounting and
"Window Dressing"
• Components of the Income Statement:
Revenues and Expenses

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Bank Financial Statements

• Report of Condition – Balance Sheet

• Report of Income – Income Statement

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Report of Condition

• The Balance Sheet of a Bank Showing its


Assets, Liabilities and Net Worth at a given
point in time

• May be viewed as a list of financial inputs


(sources of funds) and outputs (uses of
funds)

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C + S + L + MA = D + NDB + EC

C = Cash Assets
D = Deposits
NDB = Nondeposit
S = Security Holdings Borrowings
L = Loans EC = Equity Capital
MA = Miscellaneous Assets

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Cash Assets

• Account is Called Cash and Deposits Due


from Bank
• Includes:
▫ Vault Cash
▫ Deposits with Other Banks (Correspondent
Deposits)
▫ Cash Items in Process of Collection
▫ Reserve Account with the Federal Reserve
• Sometimes Called Primary Reserves

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Securities: The Liquid Portion

• Often Called Secondary Reserves


• Include:
▫ Short Term Government Securities
▫ Privately Issued Money Market Securities
 Interest Bearing Time Deposits
 Commercial Paper

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Investment Securities

• These are the Income Generating Portion of


Securities
• Taxable Securities
▫ U.S. Government Notes
▫ Government Agency Securities
▫ Corporate Bonds
• Tax-Exempt Securities
▫ Municipal Bonds

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Trading Account Assets

• Securities purchased to Provide Short-Term


Profits from Short-Term Price Movements
• When the Bank Acts as a Securities Dealer
• Valued at Market – FASB 115

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Federal Funds Sold and Reverse


Repurchase Agreements
• A Type of Loan Account
• Generally Overnight Loans
• Federal Funds Sold - Funds Come from the
Deposits at the Federal Reserve
• Reverse Repurchase Agreements – Bank
Takes Temporary Title to Securities Owned
by Borrower

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Loan Accounts
• The Major Asset
• Gross Loans – Sum of All Loans
• Allowance for Possible Loan Losses
▫ Contra Asset Account
▫ For Potential Future Loan Losses
• Net Loans
• Unearned Discount Income
• Nonperforming Loans

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Types of Loans
• Commercial and Industrial Loans
• Consumer Loans (Loans to Individuals)
• Real Estate Loans
• Financial Institution Loans
• Foreign Loans
• Agriculture Production Loans
• Security Loans
• Leases

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Allowance for Loan Losses

Beginning ALL
+ Provision for Loan Loss (Income Statement)
= Adjusted Allowance for Loan Losses
- Actual Charge-Offs
+ Recoveries from Previous Charge-Offs
= Ending Allowance for Loan Losses

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Specific and General Reserves

• Specific Reserves
▫ Set Aside to Cover a Particular Loan
▫ Designate a Portion of ALL or
▫ Add More Reserves to ALL
• General Reserves
▫ Remaining ALL
• Determined by Management But Influenced
by Taxes and Government Regulation
• Loans to Lesser Developed Countries
Require Allocated Transfer Reserves

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Miscellaneous Assets

• Bank Premises and Fixed Assets

• Other Real Estate Owned (OREO)

• Goodwill and Other Intangibles

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Deposit Accounts

• Non interest-Bearing Demand Deposits


• Savings Deposits
• Now Accounts
• Money Market Deposit Accounts (MMDA)
• Time Deposits

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Nondeposit Borrowings
• Fed Funds Purchased
• Securities Sold Under Agreement to
Repurchase (Repurchase Agreements)
• Acceptances Outstanding
• Eurocurrency Borrowings
• Subordinated Debt
• Limited Life Preferred Stock
• Other Liabilities

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Equity Capital

• Preferred Stock
• Common Stock
▫ Common Stock Outstanding
▫ Capital Surplus
▫ Retained Earnings (Undivided Profits)
▫ Treasury Stock
▫ Contingency Reserve

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Off-Balance-Sheet Items

• Unused Commitments
• Standby Credit Agreements
• Derivative Contracts
▫ Futures Contracts
▫ Options
▫ Swaps
• OBS Transactions Exposure a Firm to
Counterparty Risks

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Possible Issues
• The Problem with Book-Value Accounting
▫ Original (historical, book-value) cost
▫ Amortized cost
▫ Market-value
▫ Held-to-maturity and available-for-sale
securities
• Window Dressing
• Auditing Financial Statements
▫ Audit Committees
▫ Sarbanes-Oxley Accounting Standards Act
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Comparative
Balance Sheet
Ratios for
Different Size
Banks (FDIC,
2006)

Which accounts are most important on the asset side of a Call Report? Liability side?
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Quick Quiz
• Which are the principal accounts that
appear on a bank’s balance sheet (Report of
Condition)?
• What are primary reserves and secondary
reserves, and what are they supposed to
do?
• What are off-balance-sheet items, and why
are they important to some financial firms?

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Report of Income

• The Statement of Revenues, Expenses and Profits


for a Bank Over a Period of Time

• Shows how much it has cost to acquire funds and


to generate revenues from the uses of funds in
Report of Conditions

• Shows the revenues (cash flow) generated by


selling services to the public

• Shows net earnings after all costs are deducted


from the sum of all revenues
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Report of
Income for
BB&T
Corporation

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Net Interest Income =


Interest Income – Interest Expenses
Interest Income Interest Expenses
• Interest and Fees on Loans • Deposit Interest Costs
• Taxable Securities Revenue • Interest on Short-Term
• Tax-Exempt Securities Debt
Revenue • Interest on Long-Term Debt
• Other Interest Income

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Net Noninterest Income =


Noninterest Income – Noninterest Expenses

Noninterest Income Noninterest Expenses


• Fees Earned from Fiduciary • Wages, Salaries, and
Activities Employee Benefits
• Service Charges on Deposit
Accounts • Premises and Equipment
Expense
• Trading Account Gains and
Fees • Other Operating Expenses
• Additional Noninterest
Income

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Fees Earned from Fiduciary Activities

• Fees for Managing Protecting a Customer’s


Property
• Fees for Record Keeping for Corporate
Security Transactions and Dispensing
Interest and Dividend Payments
• Fees for Managing Corporate and Individual
Pension and Retirement Plans

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Service Charges on Deposit Accounts

• Checking Account Maintenance Fees


• Checking Account Overdraft Fees
• Fees for Writing Excessive Checks
• Savings Account Overdraft Fees
• Fess for Stopping Payment of Checks

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5-71

Trading Account Gains and Fees

• Net Gains and Losses from Trading Cash


Instruments and Off Balance Sheet
Derivative Contracts That Have Been
Recognized During the Accounting Period

McGraw-Hill/Irwin
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Bank Management and Financial Services, 7/e
5-72

Additional Noninterest Income


• Investment Banking, Advisory, Brokerage
and Underwriting
• Venture Capital Revenue
• Net Servicing Fees
• Net Securitization Income
• Insurance Commission Fees and Income
• Net Gains (Losses) on Sales of Loans
• Net Gains (Losses) on ales of Real Estate
• Net Gains (Losses) on the Sales of Other
Assets

McGraw-Hill/Irwin
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Bank Management and Financial Services, 7/e
5-73

Income Statement

Net Interest Income


- Provision for Loan Loss
Net Income After PLL
+/- Net Noninterest Income
Net Income Before Taxes
Taxes
Net Income
- Dividends
Undivided Profits
McGraw-Hill/Irwin
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Bank Management and Financial Services, 7/e
5-74

Comparative
Income Statement
Ratios for
Different Size
Banks (FDIC,
2006)

What are the most important revenue and expense items on the income statement
of a bank?
McGraw-Hill/Irwin
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Bank Management and Financial Services, 7/e
5-75

McGraw-Hill/Irwin
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Bank Management and Financial Services, 7/e
5-76

Quick Quiz
• What accounts make up the Report of Income?
• What is the relationship between the provision
for loan losses on a bank’s Report of Income
and the allowance for loan losses on its Report
of Condition?
• Suppose a bank has an allowance for loan losses of
$1.25 million at the beginning of the year, charges
current income for a $250,000 provision for loan
losses, charges off worthless loans of $150,000,
and recovers $50,000 on loans previously charged
off. What will be the balance in the allowance for
loan losses at year-end?
McGraw-Hill/Irwin
© 2008 The McGraw-Hill Companies, Inc., All Rights Reserved.
Bank Management and Financial Services, 7/e
Chapter Six
Measuring and Evaluating the
Performance of Banks and
Their Principal Competitors

McGraw-Hill/Irwin Copyright © 2010 by The McGraw-Hill Companies, Inc. All rights reserved.
6-78

Key Topics

• Stock Values and Profitability Ratios


• Measuring Credit, Liquidity, and Other Risks
• Measuring Operating Efficiency
• Performance of Competing Financial Firms
• Size and Location Effects
• The UBPR and Comparing Performance

McGraw-Hill/Irwin
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Bank Management and Financial Services, 7/e
6-79

Value of the Bank’s Stock

McGraw-Hill/Irwin
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Bank Management and Financial Services, 7/e
6-80

Value of a Bank’s Stock Rises When:

• Expected Dividends Increase


• Risk of the Bank Falls
• Market Interest Rates Decrease
• Combination of Expected Dividend Increase
and Risk Decline

McGraw-Hill/Irwin
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Bank Management and Financial Services, 7/e
6-81

Value of Bank’s Stock if Earnings Growth


is Constant

D1
P0 
r-g

McGraw-Hill/Irwin
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Bank Management and Financial Services, 7/e
6-82

Key Profitability Ratios in Banking


Net Income
Return on Equity Capital (ROE) =
Total Equity Capital
Net Income
Return on Assets (ROA) =
Total Assets
(Interestincome
- Interestexpense) Net InterestIncome
Net InterestMargin  
T otalAssets T otalAssets

Noninterest revenue
- PLLL
- Noninterest expenses Net Noninterest Income
Net Noninterest Margin  
McGraw-Hill/Irwin T otalAssets T otalAssets
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Bank Management and Financial Services, 7/e
6-83

Key Profitability Ratios in Banking (cont.)

Total Operating Revenues -


Total Operating Expenses
Net Bank Operating Margin 
Total Assets

Net IncomeAfterT axes


EarningsPer Share (EP S) 
CommonEquity Shares Outstanding

Total Interest Income __ Total Interest Expense


Earnings Spread = Total Earning Assets Total Interest Bearing Liability

McGraw-Hill/Irwin
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Bank Management and Financial Services, 7/e
6-84

Breaking Down ROE

ROE = Net Income/ Total Equity Capital

ROA = Equity Multiplier =


Net Income/Total Assets x Total Assets/Equity Capital

Net Profit Margin = x Asset Utilization =


Net Income/Total Operating Revenue Total Operating Revenue/Total Assets
McGraw-Hill/Irwin
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Bank Management and Financial Services, 7/e
6-85

ROE Depends On:


• Equity Multiplier=Total assets/Total equity capital
▫ Leverage or Financing Policies: the choice of
sources of funds (debt or equity)

• Net Profit Margin=Net income/Total operating


revenue
▫ Effectiveness of Expense Management (cost
control)

• Asset Utilization=Total operating revenue/Total


assets
▫ Portfolio Management Policies (the mix and yield
on assets)

McGraw-Hill/Irwin
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Bank Management and Financial Services, 7/e
6-86

Determinants of
ROE in a
Financial Firm

McGraw-Hill/Irwin
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6-87

Components of ROE for All Insured U.S.


Banks (1992-2007)

McGraw-Hill/Irwin
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Bank Management and Financial Services, 7/e
6-88

A Variation on ROE
Net Income Pre-Tax Net Operating Income
ROE =  
Pre-Tax Net Operating Income Total Operating Revenue
Total Operating Revenue Total Assets

Total Assets Total Equity Capital
ROE = Tax Management Efficiency 
Expense Control Efficiency 
Asset Management Efficiency 
Funds Management Efficiency
McGraw-Hill/Irwin
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Bank Management and Financial Services, 7/e
6-89

Breakdown of ROA

McGraw-Hill/Irwin
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Bank Management and Financial Services, 7/e
6-90

Quick Quiz
• What individuals or groups are likely to be
interested in the banks’ level of profitability
and exposure to risk?
• What are the principal components of ROE, and
what does each of the these components
measure?
• Suppose a bank has an ROA of 0.80% and an
equity multiplier of 12x. What is its ROE?
Suppose this bank’s ROA falls to 0.60%. What
size equity multiplier must it have to hold its
ROE unchanged?
• What are the most important components of
ROA and what aspects of a financial
institution’s performance do they reflect?
McGraw-Hill/Irwin
© 2008 The McGraw-Hill Companies, Inc., All Rights Reserved.
Bank Management and Financial Services, 7/e
6-91

Bank Risks

• Credit Risk • Legal and


• Liquidity Risk Compliance Risk
• Market Risk • Reputation Risk
• Interest Rate Risk • Strategic Risk
• Operational Risk • Capital Risk

McGraw-Hill/Irwin
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Bank Management and Financial Services, 7/e
6-92

Credit Risk

The Probability that Some of the


Financial Firm’s Assets Will
Decline in Value and Perhaps
Become Worthless

McGraw-Hill/Irwin
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Bank Management and Financial Services, 7/e
6-93

Credit Risk Measures


• Nonperforming Loans/Total Loans
• Net Charge-Offs/Total Loans
• Provision for Loan Losses/Total Loans
• Provision for Loan Losses/Equity Capital
• Allowance for Loan Losses/Total Loans
• Allowance for Loan Losses/Equity Capital
• Nonperforming Loans/Equity Capital

McGraw-Hill/Irwin
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Bank Management and Financial Services, 7/e
6-94

Liquidity Risk

Probability the Financial Firm Will


Not Have Sufficient Cash and
Borrowing Capacity to Meet
Deposit Withdrawals and Other
Cash Needs

McGraw-Hill/Irwin
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Bank Management and Financial Services, 7/e
6-95

Liquidity Risk Measures


• Purchased Funds/Total Assets
• Net Loans/Total Assets
• Cash and Due from Banks/Total
Assets
• Cash and Government
Securities/Total Assets

McGraw-Hill/Irwin
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Bank Management and Financial Services, 7/e
6-96

Market Risk: Comprises Price Risk


and Interest Rate Risk

Probability of the Market Value of the


Financial Firm’s Investment Portfolio
Declining in Value Due to a Change in
Interest Rates

McGraw-Hill/Irwin
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Bank Management and Financial Services, 7/e
6-97

Market Risk Measures

• Book-Value of Assets/ Market Value of


Assets
• Book-Value of Equity/ Market Value of
Equity
• Book-Value of Bonds/Market Value of
Bonds
• Market Value of Preferred Stock and
Common Stock

McGraw-Hill/Irwin
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Bank Management and Financial Services, 7/e
6-98

Interest Rate Risk

The Danger that Shifting Interest


Rates May Adversely Affect a Bank’s
Net Income, the Value of its Assets
or Equity

McGraw-Hill/Irwin
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Bank Management and Financial Services, 7/e
6-99

Interest Rate Risk Measures

• Interest Sensitive Assets/Interest


Sensitive Liabilities

• Uninsured Deposits/Total Deposits

McGraw-Hill/Irwin
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Bank Management and Financial Services, 7/e
6-100

Off-Balance-Sheet Risk
The Volatility in Income and Market Value of
Bank Equity that May Arise from
Unanticipated Losses due to OBS Activities
(activities that do not have a balance sheet
reporting impact until a transaction is
affected)

McGraw-Hill/Irwin
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Bank Management and Financial Services, 7/e
6-101

Operational Risk
Uncertainty Regarding a Financial
Firm’s Earnings Due to Failures in
Computer Systems, Errors, Misconduct
by Employees, Floods, Lightening
Strikes and Similar Events or Risk of
Loss Due to Unexpected Operating
Expenses

McGraw-Hill/Irwin
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Bank Management and Financial Services, 7/e
6-102

Legal and Compliance Risk

Risk of Earnings Resulting from Actions


Taken by the Legal System. This can
Include Unenforceable Contracts, Lawsuits
or Adverse Judgments. Compliance Risk
Includes Violations of Rules and Regulations

McGraw-Hill/Irwin
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Bank Management and Financial Services, 7/e
6-103

Reputation Risk

This is Risk Due to Negative Publicity that


can Dissuade Customers from Using the
Services of the Financial Firm. It is the Risk
Associated with Public Opinion.

McGraw-Hill/Irwin
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Bank Management and Financial Services, 7/e
6-104

Capital Risk

Probability of the Value of the Bank’s


Assets Declining Below the Level of its
Total Liabilities. The Probability of the
Bank’s Long Run Survival

McGraw-Hill/Irwin
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Bank Management and Financial Services, 7/e
6-105

Capital Risk Measures

• Stock Price/Earnings Per Share


• Equity Capital/Total Assets
• Purchased Funds/Total Liabilities
• Equity Capital/Risk Assets

McGraw-Hill/Irwin
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Bank Management and Financial Services, 7/e
6-106

Other Goals in Banking


Total Operating Expenses
Operating Efficiency Ratio =
Total Operating Revenues

Net Operating Income


Employee Productivity Ratio =
Number of Full Time-Equivalent Employees

McGraw-Hill/Irwin
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Bank Management and Financial Services, 7/e
6-107

Performance Indicators Related to


the Size of a Firm, 2007

McGraw-Hill/Irwin
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Bank Management and Financial Services, 7/e
6-108

Appendix: UBPR
The Uniform Bank Performance
Report Provided by U.S. Federal
Regulators so that Analysts Can
Compare the Performance of One
Bank Against Another

Web link for UBPR and BHCPR:


www.ffiec.gov

McGraw-Hill/Irwin
© 2008 The McGraw-Hill Companies, Inc., All Rights Reserved.
Bank Management and Financial Services, 7/e
Chapter Seven

Risk Management for Changing


Interest Rates: Asset-Liability
Management and Duration Techniques

McGraw-Hill/Irwin Copyright © 2010 by The McGraw-Hill Companies, Inc. All rights reserved.
7-110

Key Topics

• Asset, Liability, and Funds Management


• Market Rates and Interest-Rate Risk
• The Goals of Interest-Rate Hedging
• Interest-Sensitive Gap Management
• Duration Gap Management
• Limitations of Hedging Techniques

McGraw-Hill/Irwin
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Bank Management and Financial Services, 7/e
7-111

Asset-Liability Management

The Purpose of Asset-Liability


Management is to Control a Bank’s
Sensitivity to Changes in Market
Interest Rates and Limit its Losses in
its Net Income or Equity

McGraw-Hill/Irwin
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Bank Management and Financial Services, 7/e
7-112

Historical View of Asset-Liability


Management
• Asset Management Strategy (control
over assets, no control over liabilities)
• Liability Management Strategy (control
over liabilities by changing rates and
other terms)
• Funds Management Strategy (work
with both strategies)

McGraw-Hill/Irwin
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Bank Management and Financial Services, 7/e
7-113

Interest Rate Risk

• Price Risk
▫ When Interest Rates Rise, the Market Value
of the Bond or Asset Falls
• Reinvestment Risk
▫ When Interest Rates Fall, the Coupon
Payments on the Bond are Reinvested at
Lower Rates

McGraw-Hill/Irwin
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Bank Management and Financial Services, 7/e
7-114

Interest Rate Risk: One of the Main


Challenges
• Forces Determining Interest Rates
▫ Loanable Funds Theory

• The Measurement of Interest Rates


▫ YTM
▫ Bank Discount

• Components of Interest Rates

McGraw-Hill/Irwin
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Bank Management and Financial Services, 7/e
7-115

Yield to Maturity (YTM)

n
CFt
Market Price  
t 1 (1  YTM)
t

McGraw-Hill/Irwin
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Bank Management and Financial Services, 7/e
7-116

Bank Discount Rate (DR)

FV - Purchase Price 360


DR  *
FV # Days to Maturity

Where: FV equals Face Value of a Security,


such as Treasury Bills
McGraw-Hill/Irwin
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Bank Management and Financial Services, 7/e
7-117

Market Interest Rates


Function of:
• Risk-Free Real Rate of Interest
• Various Risk Premiums
▫ Default Risk
▫ Inflation Risk
▫ Liquidity Risk
▫ Call Risk
▫ Maturity Risk

McGraw-Hill/Irwin
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Bank Management and Financial Services, 7/e
7-118

Yield Curves
• Graphical Picture of Relationship Between
Yields and Maturities on Securities
• Generally Created With Treasury Securities
to Keep Default Risk Constant
• Shape of the Yield Curve
▫ Upward – Long-Term Rates Higher than Short-
Term Rates
▫ Downward – Short-Term Rates Higher than Long-
Term Rates
▫ Horizontal – Short-Term and Long-Term Rates
the Same
• Shape of the Yield Curve and a Maturity Gap
McGraw-Hill/Irwin
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Bank Management and Financial Services, 7/e
7-119

Net Interest Margin

Interest Income - Interest Expenses


NIM 
Total Earnings Assets

McGraw-Hill/Irwin
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Bank Management and Financial Services, 7/e
7-120

Goal of Interest Rate Hedging

One Important Goal of Interest Rate


Hedging is to Insulate the Bank from
the Damaging Effects of Fluctuating
Interest Rates on Profits

McGraw-Hill/Irwin
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Bank Management and Financial Services, 7/e
7-121

Quick Quiz
• What forces cause interest rates to change?
• What makes it so difficult to correctly forecast
interest rate changes?
• What is the yield curve, and why is it important
to know about its shape and slope?
• What is the goal of hedging?
• First National Bank of Bannerville has posted interest
revenues of $63 million and interest costs from all of its
borrowings of $42 million. If this bank possesses $700
million in total earning assets, what is First National’s
net interest margin? Suppose the bank’s interest
revenues and interest costs double, while its earning
assets increase by 50%. What will happen to its net
interest margin?
McGraw-Hill/Irwin
© 2008 The McGraw-Hill Companies, Inc., All Rights Reserved.
Bank Management and Financial Services, 7/e
7-122

Interest-Sensitive Gap Measurements

Dollar Interest- Interest-Sensitive Assets –


Sensitive Gap = Interest Sensitive Liabilities

Relative
Dollar IS Gap
Interest- 
Sensitive Gap Bank Size

Interest InterestSensitiveAssets
Sensitivity 
InterestSensitiveLiabilities
Ratio

McGraw-Hill/Irwin
© 2008 The McGraw-Hill Companies, Inc., All Rights Reserved.
Bank Management and Financial Services, 7/e
7-123

Examples of Repriceable (Interest


Sensitive) Assets and Liabilities

McGraw-Hill/Irwin
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Bank Management and Financial Services, 7/e
7-124

Asset-Sensitive Bank Has:

• Positive Dollar Interest-Sensitive Gap

• Positive Relative Interest-Sensitive Gap

• Interest Sensitivity Ratio Greater Than


One

McGraw-Hill/Irwin
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Bank Management and Financial Services, 7/e
7-125

Liability Sensitive Bank Has:

• Negative Dollar Interest-Sensitive Gap

• Negative Relative Interest-Sensitive


Gap

• Interest Sensitivity Ratio Less Than


One
McGraw-Hill/Irwin
© 2008 The McGraw-Hill Companies, Inc., All Rights Reserved.
Bank Management and Financial Services, 7/e
7-126

Computer-Based Techniques and


Maturity Buckets

McGraw-Hill/Irwin
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Bank Management and Financial Services, 7/e
7-127

Gap Positions and the Effect of


Interest Rate Changes on the Bank

• Asset-Sensitive • Liability-
Bank Sensitive Bank
▫ Interest Rates Rise ▫ Interest Rates Rise
 NIM Rises  NIM Falls
▫ Interest Rates Fall ▫ Interest Rates Fall
 NIM Falls  NIM Rises

McGraw-Hill/Irwin
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Bank Management and Financial Services, 7/e
7-128

Zero Interest-Sensitive Gap

• Dollar Interest-Sensitive Gap is Zero


• Relative Interest-Sensitive Gap is Zero
• Interest Sensitivity Ratio is One
▫ When Interest Rates Change in Either
Direction - NIM is Protected and Will Not
Change

McGraw-Hill/Irwin
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Bank Management and Financial Services, 7/e
7-129

Important Decision Regarding IS Gap

• Management Must Choose the Time Period


Over Which NIM is to be Managed
• Management Must Choose a Target NIM
• To Increase NIM Management Must Either:
▫ Develop Correct Interest Rate Forecast
▫ Reallocate Assets and Liabilities to Increase
Spread
• Management Must Choose Volume of
Interest-Sensitive Assets and Liabilities

McGraw-Hill/Irwin
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Bank Management and Financial Services, 7/e
7-130

NIM Influenced By:

• Changes in Interest Rates Up or Down


• Changes in the Spread Between Assets and
Liabilities
• Changes in the Volume of Interest-Sensitive
Assets and Liabilities
• Changes in the Mix of Assets and Liabilities

McGraw-Hill/Irwin
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Bank Management and Financial Services, 7/e
7-131

Cumulative Gap

The Total Difference in Dollars


Between Those Bank Assets and
Liabilities Which Can be Repriced over
a Designated Time Period

McGraw-Hill/Irwin
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Bank Management and Financial Services, 7/e
7-132

Aggressive Interest-Sensitive Gap


Management

McGraw-Hill/Irwin
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Bank Management and Financial Services, 7/e
7-133

Problems with Interest-Sensitive Gap


Management
• Interest Paid on Liabilities Tend to Move Faster
than Interest Rates Earned on Assets
• Interest Rate Attached to Bank Assets and
Liabilities Do Not Move at the Same Speed as
Market Interest Rates
• Point at Which Some Assets and Liabilities are
Repriced is Not Easy to Identify
• Interest-Sensitive Gap Does Not Consider the
Impact of Changing Interest Rates on Equity
Position

McGraw-Hill/Irwin
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Bank Management and Financial Services, 7/e
7-134

Quick Quiz
• Commerce National Bank reports interest-sensitive assets of
$870 million and interest-sensitive liabilities of $625 million
during the coming month. Is the bank asset sensitive or
liability sensitive? What is likely to happen to the bank’s net
interest margin if interest rates rise? If they fall?

• People’s Savings Bank , a thrift institutions, has a cumulative


gap for the coming year of +$135 million, and interest rates
are expected to fall by two and a half percentage points.
Calculate the expected change in net interest income that this
thrift institution might experience. What will occur in net
interest income if interest rates rise by one and a quarter
percentage points?

McGraw-Hill/Irwin
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Bank Management and Financial Services, 7/e
7-135

The Concept of Duration

Duration is the Weighted Average


Maturity of a Promised Stream of
Future Cash Flows

McGraw-Hill/Irwin
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Bank Management and Financial Services, 7/e
7-136

To Calculate the Instrument’s Duration

n n

 (1 YT M) t * CFt
t  (1 YT M) t * CFt
t
D  t 1  t 1
n Current MarketValue or P rice
 (1 YT M)
t 1
CFt
t

McGraw-Hill/Irwin
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Bank Management and Financial Services, 7/e
7-137

Price Sensitivity of a Security

P i
 -D*
P (1  i)

McGraw-Hill/Irwin
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Bank Management and Financial Services, 7/e
7-138

Convexity

The Rate of Change in an Asset’s Price


or Value Varies with the Level of
Interest Rates or Yields

McGraw-Hill/Irwin
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Bank Management and Financial Services, 7/e
7-139

Dollar-Weighted Duration of Asset


Portfolio
n
D A   w i * D Ai
i 1

Where:
wi = the dollar amount of the ith asset divided by total assets
DAi = the duration of the ith asset in the portfolio

McGraw-Hill/Irwin
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Bank Management and Financial Services, 7/e
7-140

Dollar-Weighted Duration of a Liability


Portfolio
n
D L   w i * D Li
i 1

Where:
wi = the dollar amount of the ith liability divided by total liabilities
DLi = the duration of the ith liability in the portfolio

McGraw-Hill/Irwin
© 2008 The McGraw-Hill Companies, Inc., All Rights Reserved.
Bank Management and Financial Services, 7/e
7-141

Duration Gap

TL
D  DA - DL *
TA

McGraw-Hill/Irwin
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Bank Management and Financial Services, 7/e
7-142

Change in the Value of a Bank’s Net


Worth

 i   i 
NW  - D A * * A  - - D L * * L
 (1  i)   (1  i) 

McGraw-Hill/Irwin
© 2008 The McGraw-Hill Companies, Inc., All Rights Reserved.
Bank Management and Financial Services, 7/e
7-143

Impact of Changing Interest Rates on a


Bank’s Net Worth

McGraw-Hill/Irwin
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Bank Management and Financial Services, 7/e
7-144

Limitations of Duration Gap Management


• Finding Assets and Liabilities of the Same
Duration Can be Difficult
• Some Assets and Liabilities May Have
Patterns of Cash Flows that are Not Well
Defined
• Customer Prepayments May Distort the
Expected Cash Flows in Duration
• Customer Defaults May Distort the Expected
Cash Flows in Duration
• Convexity Can Cause Problems

McGraw-Hill/Irwin
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Bank Management and Financial Services, 7/e
7-145

Quick Quiz
• What is duration? How is a financial
institution’s duration gap determined?
• What are the advantages of using duration as
opposed to interest-sensitive gap analysis?
• Suppose that a thrift institution has an average
asset duration of 2.5 years and an average
liability duration of 3.0 years. If the thrift holds
total assets of $560 million and total liabilities
of $467 million, does it have a significant
leverage-adjusted duration gap? If interest
rates rise, what will happen to the value of its
net worth?
McGraw-Hill/Irwin
© 2008 The McGraw-Hill Companies, Inc., All Rights Reserved.
Bank Management and Financial Services, 7/e
Chapter Eight

Risk Management: Financial Futures, Options,


Swaps, and Other Hedging Tools

McGraw-Hill/Irwin Copyright © 2010 by The McGraw-Hill Companies, Inc. All rights reserved.
8-147

Key Topics
• The Use of Derivatives
• Financial Futures Contracts: Purpose and
Mechanics
• Short and Long Hedges
• Interest-Rate Options: Types of Contracts
and Mechanics
• Interest-Rate Swaps
• Regulations and Accounting Rules
• Caps, Floors, and Collars
McGraw-Hill/Irwin
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Bank Management and Financial Services, 7/e
8-148

Derivatives

A Derivative is Any Instrument or


Contract that Derives its Value From
Another Underlying Asset, Instrument,
or Contract, Such as Treasury Bills and
Bonds and Eurodollar Deposits

McGraw-Hill/Irwin
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8-149

Managing Interest Rate Risk


• Derivatives Used to Manage Interest Rate
Risk
▫ Financial Futures Contracts
▫ Forward Rate Agreements
▫ Interest Rate Swaps
▫ Options on Interest Rates
 Interest Rate Caps
 Interest Rate Floors
 Interest Rate Collars

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Financial Futures Contract


• An Agreement Between a Buyer and a Seller
Which Calls for the Delivery of a Particular
Financial Asset at a Set Price at Some Future
Date
• Futures Markets
▫ The Organized Exchanges Where Futures
Contracts are traded
• Interest Rate Futures
▫ Where the Underlying Asset is an Interest-
Bearing Security
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Financial Futures Contracts


IS Gap = IS Assets – IS Liabilities

and

TL
D  DA - DL *
TA
Recall what happens when interest rates rise? Fall?

One of the most popular methods for neutralizing these gap


risks is to buy and sell financial futures contracts
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Background on Financial Futures


• Buyers
▫ A buyer of a futures contract is said to be
long futures

▫ Agrees to pay the underlying futures price


or take delivery of the underlying asset

▫ Buyers gain when futures prices rise and


lose when futures prices fall

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Background on Financial Futures


• Sellers
▫ A seller of a futures contract is said to be
short futures

▫ Agrees to receive the underlying futures


price or to deliver the underlying asset

▫ Sellers gain when futures prices fall and


lose when futures prices rise
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The Purpose of Financial Futures

To Shift the Risk of Interest Rate


Fluctuations from Risk-Averse
Investors to Speculators

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The World’s Leading Futures and Option


Exchanges
• Chicago Board of • Euronext.Liffe
Trade (CBT) (Eurex)
• Chicago Board • Sydney Futures
Options Exchange Exchange
• Singapore Exchange • Toronto Futures
Exchange (TFE)
LTD. (SGX)
• South African
• Chicago Mercantile Futures Exchange
Exchange (CME) (SAFEX)

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Futures vs. Forward Contracts


▫ Futures Contracts
 Traded on formal exchanges (CBOT, CME, etc.)
 Involve standardized instruments
 Positions require a daily marking to market

▫ Forward Contracts
 Terms are negotiated between parties
 Do not necessarily involve standardized assets
 Require no cash exchange until expiration
 No marking to market

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Most Common Financial Futures


Contracts

• U.S. Treasury Bond Futures Contracts


• Three-Month Eurodollar Time Deposit
Futures Contract
• 30-Day Federal Funds Futures Contracts
• One Month LIBOR Futures Contracts

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Hedging with Futures Contracts


Avoiding Higher Use a Short Hedge: Sell


Borrowing Costs and Futures Contracts and
Declining Asset Values then Purchase Similar
Contracts Later


Avoiding Lower Than Use a long Hedge: Buy
Expected Yields from Futures Contracts and
Loans and Securities then Sell Similar
Contracts Later

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8-159

Short Futures Hedge Process


• Today – Contract is Sold Through an
Exchange

• Sometime in the Future – Contract is


Purchased Through the Same Exchange

• Results – The Two Contracts Are Cancelled


Out by the Futures Clearinghouse

• Gain or Loss is the Difference in the Price


Purchased for (At the End) and Price Sold
For (At the Beginning)
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Long Futures Hedge Process


• Today – Contract is Purchased Through an
Exchange

• Sometime in the Future – Contract is sold


Through the Same Exchange

• Results – The Two Contracts are Cancelled


by the Clearinghouse

• Gain or Loss is the Difference in the Price


Purchase For (At the Beginning) and the
Price Sold For (At the End)
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Basis Risk
The basis is the cash price of an asset minus
the corresponding futures price for the
same asset at a point in time
▫ For financial futures, the basis can be calculated as
the futures rate minus the spot rate
▫ It may be positive or negative, depending on whether
futures rates are above or below spot rates
▫ May swing widely in value far in advance of contract
expiration

Basis=Cash-market price (or interest rate) –


futures market price (or interest rate)
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8-162

Realized Return from Combining Cash


and Futures Market Trading
= Return Earned in the Cash Market

+/- Profit or Loss from Futures Trading

- Closing Basis Between Cash and Futures


Market

- Opening Basis Between Cash and Futures


Market

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Change in the Market Value of the


Futures Contract

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Change in the Market Value of the


Futures Contract

i
Ft  F0  -D  F0  N 
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(1  i)
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Number of Futures Contracts


Needed

TL
(D A - D L * ) * TA
 TA
D F * Price of the Futures Contract

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Quick Quiz
• What are financial futures contracts? Which
financial institutions use futures and other
derivatives for risk management?

• How can financial futures help financial


service firms deal with interest rate risk?

• What futures transactions would most likely


be used in a period of rising interest rates?
Falling interest rates?
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8-167

Interest Rate Option

It Grants the Holder of the Option the


Right but Not the Obligation to Buy or
Sell Specific Financial Instruments at
an Agreed Upon Price.

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8-168

Types of Options

• Put Option
▫ Gives the Holder of the Option the
Right to Sell the Financial Instrument
at a Set Price
• Call Option
▫ Gives the Holder of the Option the
Right to Purchase the Financial
Instrument at a Set Price

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8-169

Most Common Option Contracts


Used By Banks

• U.S. Treasury Bond Futures Options

• Eurodollar Futures Option

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Principal Uses of Option Contracts


• 1. Protecting a security portfolio through the use of put
options to insulate against falling security prices (rising
interest rates); however, there is no delivery obligation
under an option contract so the user can benefit from
keeping his or her securities if interest rates fall and
security prices rise

• 2. Hedging against positive or negative gaps between


interest-sensitive assets and interest- sensitive
liabilities; for example, put options can be used to
offset losses from a negative gap when interest rates
rise, while call options can be used to offset a positive
gap when interest rates fall.
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Speculation vs. Hedging


• With financial futures, risk often cannot be
eliminated, only reduced.
▫ Traders normally assume basis risk in that
the basis might change adversely between
the time the hedge is initiated and closed
• Perfect Hedge
▫ The gains (losses) from the futures position
perfectly offset the losses (gains) on the spot
position at each price

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Federal Funds Options and Futures

• Represents the Consensus Opinion Of the


Likely Future Course of Market Interest
Rates
• Public Trading for Futures Contract Began
at the CBOT in 1988
• Public Trading on Options Contracts Began
in 2003

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Regulations For Options and Future


Contracts

• OCC – Risk Management of Financial


Derivatives: Comptrollers Handbook
• FASB – Statement 133 – Accounting for
Derivatives Instruments and Hedging
Activities

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Interest Rate Swap

A Contract Between Two Parties to


Exchange Interest Payments in an
Effort to Save Money and Hedge
Against Interest-Rate Risk

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Interest –Rate Swap

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Quality Swap

• Borrower with Lower Credit Rating


Pays Fixed Payments of Borrower with
Higher Credit Rating
• Borrower with Higher Credit Rating
Pays Short-Term Floating Rate
Payments of Borrower with Lower
Credit Rating

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Further…
• Firms with a negative GAP can reduce risk
by making a fixed-rate interest payment in
exchange for a floating-rate interest receipt

• Firms with a positive GAP take the opposite


position, by making floating-interest
payments in exchange for a fixed-rate
receipt

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Risks of Interest Rate Swaps


• Substantial Brokerage Fees
• Credit Risk
▫ The counterparty may default on the exchange of
the interest payments
▫ Only the interest payment exchange is at risk,
not the principal
• Basis Risk
▫ A swap’s reference interest rates are not the
same as those attached to all the assets and
liabilities (LIBOR, bond rates, etc.), so rates do
not change exactly the same -> some risk
remains
• Interest Rate Risk

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Netting

The Swap Parties Only Swap the Net


Difference Between the Interest
Payments. This Reduces the Potential
Damage if One Party Defaults on its
Obligation

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Currency Swap

An Agreement Between Two Parties,


Each Owing Funds to Other
Contractors Denominated in Different
Currencies, to Exchange the Needed
Currencies with Each Other and Honor
Their Respective Contracts.

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Interest Rate Cap

Protects the Holder from Rising


Interest Rates. For an Up Front Fee
Borrowers are Assured Their Loan Rate
Will Not Rise Above the Cap Rate

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Interest Rate Floor

A Contract Setting the Lowest Interest


Rate a Borrower is Allowed to Pay on a
Flexible-Rate Loan

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Interest Rate Collar

A Contract Setting the Maximum and


Minimum Interest Rates That May Be
Assessed on a Flexible-Rate Loan. It
Combines an Interest Rate Cap and
Floor into One Contract.

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Quick Quiz

• Explain what is involved in a put option?


• What is a call option?
• Suppose market interest rates were
expected to rise. What type of option would
normally be used?
• If rates were expected to fall, what type of
option would a financial institution’s
manager be likely to employ?

McGraw-Hill/Irwin
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Bank Management and Financial Services, 7/e
Chapter Nine

Risk Management: Asset-Backed


Securities, Loan Sales, Credit Standbys,
and Credit Derivatives
McGraw-Hill/Irwin Copyright © 2010 by The McGraw-Hill Companies, Inc. All rights reserved.
9-188

Key Topics
• The Securitization Process

• Securitization’s Impact and Risks

• Sales of Loans: Nature and Risks

• Standby Credits: Pricing and Risks

• Credit Derivatives and CDOs

• Benefits and Risks of Credit Derivatives


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Securitization of Loans

The Pooling of a Group of Similar


Loans and Issuing Securities Against
the Pool Whose Return Depends on
the Stream of Interest and Principal
Payments Generated by the Loans

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The Heart of the


Securitization Process

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Securitization Process
• Originator – Bank or Lender Who Makes the
Loan
• Issuer – Special Purpose Entity That Issues
the Securities
• Credit Rating Agency – Rates the Securities
• Security Underwriter or Investment Banker
Helps Issue Securities
• Trustee – Makes Sure Issuer Fulfills All
Their Obligations
• Servicer- Collects Payments on the
Securitized Loans
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Key Players in the Securitization Process

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Advantages of Securitization
• Diversifies a Bank’s Credit Risk Exposure
• Creates Liquid Assets Out of Illiquid Assets
• Transforms These Assets into New Sources
of Capital
• Allows the Bank to Hold a More
Geographically Diversified Loan Portfolio
• Allows the Bank to Better Manage Interest
Rate Risk
• Allows the Bank to Generate Fee Income

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Problems with Securitization


• May Not Reduce a Bank’s Capital Requirements
• Prepayment Risk
• May Increase Competition for the Best Quality
Loans
• May Increase Competition for Deposits
• Credit Crisis of 2007-2009 showed that the
“bankruptcy remote” SPE arrangements can get
into trouble if the underlying loans go bad
• GSEs: Ethical Controversies Around Fannie Mae
and Freddie Mac

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Promised Fees and Payments on


Securitized Loans
• Coupon Rate Promised to Investors Who Buy
Securities
• Default Rate on the Pooled Loans
• Fees to Compensate for Servicing Loans
• Fees Paid to Advise on Setting Up
Securitization Process
• Fees Paid for Providing Liquidity
Enhancement
• Residual Income For Security Seller, Trust or
Credit Enhancer

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Types of Securitized Assets


• Residential Mortgages – the beginnings of
securitization
▫ The role of GSEs (GNMA, FNMA, FHLMC)
▫ Riskier CMOs
• Home Equity Loans
• Automobile Loans (CARs)
• Commercial Mortgages
• Small Business Administration Loans
• Mobile Home Loans
• Credit Card Receivables
• Truck Leases
• Computer Leases

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9-197

Regulators’ Concerns About The Soundness and


Safety of Lenders and Financial System
• Risk of Having to Come Up with Large Amounts of Liquidity
Quickly to Make Payments To Investors Holding Securities
• Risk of Agreeing to Serve as Underwriter for Securities that
Cannot be Sold
• Risk of Acting as Credit Enhancer and Underestimating
Need for Loan Reserves
• Risk that Unqualified Trustees Will Fail to Protect Investors
• Risk of Loan Servicers Being Unable to Satisfactorily
Monitor Loan Performance and Collect Monies Owed
• In light of the credit crisis, also focus on the impact of
securitization on the remaining portfolio of loans that are
not securitized

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Quick Quiz
• What does securitization of assets mean?

• What kinds of assets are most amenable to


the securitization process?

• What advantages does securitization offer


lending institutions?

• What are the most important risks


associated with the securitization process
(from the lending institution and the
regulators’ perspectives)?
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9-199

Loan Sales

Selling Loan Contracts Held by an


Institution in Order to Raise New Cash

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9-200

The Impact of Loan Sales

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Servicing Rights

The Selling Bank Can Generate Fees


for Agreeing to Keep Records, Collect
Monies Owed and Help Enforce the
Terms of a Group of Loan Contracts
and Passing the Proceeds on to the
Loan Buyers

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Types of Loan Sales


• Participation Loans
▫ Where an Outside Party Purchases a Loan. They
Generally Have No Influence Over the Loan Terms

• Assignments
▫ Ownership of the Loan is Transferred to the
Buyer of the Loan. The Buyer Has a Direct Claim
Against the Borrower.

• Loan Strip
▫ Short-Dated Pieces of Longer Term Loans,
Maturing in a Few Days or Weeks

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Reasons Behind Loan Sales


• Way to Rid the Bank of Lower-Yielding
Assets to Make Room for Higher-Yielding
Assets when Interest Rates Rise
• Way to Increase Marketability and Liquidity
of Assets
• Way to Eliminate Credit and Interest Rate
Risk
• Way to Generate Fee Income
• Purchasing Bank can Diversify Loan Portfolio
and Reduce Risk

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9-204

Risks In Loan Sales


• Best Quality Loans are the Easiest to Sell
Which May Increase Volatility of Earnings for
the Bank Which Sells the Loans

• Loan Purchased From Another Bank Can


Turn Bad Just as Easily As One From Their
Own Bank

• Loan Sales are Cyclical

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9-205

Standby Letters of Credit (SLCs)


• Financial Instrument that Enhances the
Credit Standing of a Borrower by Providing
Guarantees of Performance or Insures
Against Default in Return for Payment of a
Fee. It is a Contingent Obligation

▫ Performance Guarantees – Guarantees a


Project Will be Completed On Time
▫ Default Guarantees – Financial Institution
Pledges Repayment of Defaulted Notes When
Borrowers Cannot Pay
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Advantages of SLCs

• Letters of Credit Earn a Fee for Providing


the Service (0.5 to 1 percent of the amount
of credit involved)
• They Aid a Customer Who Can Borrow More
Cheaply When There is a Guarantee
• Such Guarantees Can be Issued at Relatively
Low Cost
• Probability is Usually Low that an Issuer of
SLC Will Ever Be Called On to Pay
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Reasons for Growth of SLCs

• Rapid Growth of Direct Financing Worldwide

• Risk of Economic Fluctuations has led to


Demand for Risk-Reducing Devices

• Opportunity SLCs Offer Lenders to Use


Their Credit Evaluation Skills to Earn Fee
Income Without the Immediate Commitment
of Funds

• The Relatively Low Cost of Issuing SLCs


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Structure of SLCs
Three Essential Elements:
• Commitment From Issuer

• An Account Party – For Whom the


Letter is Issued

• A Beneficiary – Investor Concerned


About Funds Committed to Account
Party

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Sources of Risk with SLCs


• Default Risk of Issuing Bank

• Beneficiary Must Meet All Conditions


of Letter to Receive Payment

• Bankruptcy Laws Can Cause Problems


for SLCs

• Issuer Faces Substantial Interest Rate


and Liquidity Risks
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9-210

Ways to Reduce Risk Exposure of SLCs

• Frequently Renegotiating the Terms of Any


Loans Extended to Customers

• Diversifying SLCs Issued by Region and


Industry

• Selling Participations in Standbys in Order


to Share Risk

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9-211

Regulatory Concerns About SLCs

• Bank Examiners are Working to Keep Risk


Exposure Under Control Leading to New
Regulatory Rules:
▫ Banks Must Apply the Same Credit Standards
to SLCs as for Loans
▫ Banks Must Count SLCs as Loans When
Assessing Risk Exposure to a Single
Customer
▫ Banks Must Post Capital Behind Most SLCs

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9-212

Credit Derivatives
• Over-the-Counter Financial Agreements
Offering Protection to a Designated
Beneficiary in Case of Default on a Loan,
bond, or Other Debt Instruments

• Was One of the Fastest-Growing


Markets, but the Credit Crisis Uncovered
Problems with Recordkeeping and
Possible Increasing Risk Exposure
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9-213

Types of Credit Derivatives


• Credit Swaps
• Credit Options
• Credit Default Swaps
• Credit Linked Notes
• Collateralized Debt Obligations

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9-214

Credit Swaps
• Two Lenders Agree to Swap a Portion of
Their Customer’s Loan Payments
• Can Help Each Lender Further Spread Out
Their Risk
• Variation is a Total Return Swap Where the
Dealer Guarantees Parties a Specific Rate of
Return

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9-215

Credit Options
Guards Against Losses in Value of a Credit
Asset or Helps Offset Higher Borrowing
Costs Due to Changes in Credit Ratings of
the Borrower

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Credit Default Swaps


Aimed at Lenders Able to Handle
Comparatively Limited Declines in Value But
Who Want Insurance Against Serious Losses

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Credit Linked Notes

• Fuses Together a Normal Debt Instrument


with a Credit Option Contract to Give
Borrower Greater Payment Flexibility

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9-218

Collateralized Debt Obligations


• Contain Pools of High-Yield Corporate Bonds,
Stocks or Other Financial Instruments
Contributed by Businesses Interested In
Strengthening Their Balance Sheets and Raising
New Funds. Notes of Varying Grades are Sold
to Investors Seeing Income From Pooled Assets
• The Credit and Liquidity Crisis of 2007-2009
has Exposed
▫ The Complexity of These Instruments
▫ Questionable Credit Ratings Assignments
▫ Huge Write-Downs of CDO Values Worldwide

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9-219

Risks of Credit Derivatives


• Partners in Swap or Option Contract May Fail to
Perform
• Smaller Volume – Markets are Thinner and More
Volatile
• Legal Issues
• Regulatory Concerns
• Lessons of Credit Crisis:
▫ Securitized Assets and Credit Swaps are Complex
Financial Instruments that are Difficult to Correctly
Value and Measure in Terms of Risk Exposures
▫ Operate in Cyclically Sensitive Markets
▫ Contagion Effect Cannot be Stopped without Active
Government Intervention

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Bank Management and Financial Services, 7/e
Chapter Eleven

Liquidity and Reserves Management:


Strategies and Policies
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Liquidity

• The Availability of Cash in the Amount and


at the Time Needed at a Reasonable Cost

• The size and volatility of cash requirements


affect the liquidity position of the bank
▫ Examples of transaction that affect the bank’s
cash balance and liquidity position: Deposits
and withdrawals; loan disbursements and
loan payments

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Supplies of Liquid Funds

• Incoming Customer Deposits

• Revenues from the Sale of Nondeposit


Services

• Customer Loan Repayments

• Sales of Bank Assets

• Borrowings from the Money Market

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Demands for Liquidity


• Customer Deposit Withdrawals

• Credit Requests from Quality Loan


Customers

• Repayment of Nondeposit Borrowings

• Operating Expenses and Taxes

• Payment of Stockholder Dividends


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A Financial Firm’s Net Liquidity


Position

L = Supplies of Liquid Funds


- Demands for Liquidity

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Quick Quiz: Comprehensive Problem


Suppose that a bank faces the following cash inflows and outflows
during the coming week:
a) deposit withdrawals are expected to total $33 million;
b) customer loan repayments are expected to amount to $108
million;
c) Operating expenses demanding cash payment will probably
approach $51 million;
d) Acceptable new loan requests should reach $294 million;
e) Sales of bank assets are projected to be $18 million;
f) New deposits should total $670 million;
g) Borrowings from the money market are expected to be about $43
million;
h) Nondeposit service fees should amount to $27 million;
i) Previous bank borrowings totaling $23 million are scheduled to be
repaid; and
j) A dividend payment to bank stockholders of $140 million is
scheduled.
What is this bank’s projected net liquidity position for the coming
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week?
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Essence of Liquidity Management


• Rarely are the Demands for Liquidity Equal
to the Supply of Liquidity at Any Particular
Moment. The Financial Firm Must
Continually Deal with Either a Liquidity
Deficit or Surplus
• There is a Trade-Off Between Liquidity and
Profitability. The More Resources Tied Up
in Readiness to Meet Demands for Liquidity,
the Lower is the Financial Firm’s Expected
Profitability.

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Why Banks and Their Competitors


Face Significant Liquidity Problems
• Imbalances Between Maturity Dates of Their Assets and
Liabilities

• High Proportion of Liabilities (especially demand


deposits and money market borrowings) Subject to
Immediate Repayment

• Sensitivity to Changes in Interest Rates


▫ May affect customer demand for deposits
▫ May affect customer demand for loans

• Central Role in the Payment Process, Reputation and


Public Confidence in the System

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Strategies for Liquidity Managers


1. Think about what is a liquid asset?
2. Identify strategies for liquidity
management.

• Asset Liquidity Management or Asset


Conversion Strategy

• Borrowed Liquidity or Liability


Management Strategy

• Balanced Liquidity Strategy


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Asset Liquidity Management

This Strategy Calls for Storing


Liquidity in the Form of Liquid Assets
(T-bills, fed funds loans, CDs, etc.)
and Selling Them When Liquidity is
Needed

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Liquid Asset

• Must Have a Ready Market So it Can Be


Converted to Cash Quickly

• Must Have a Reasonably Stable Price

• Must Be Reversible So an Investor Can


Recover Original Investment with Little
Risk

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Options for Storing Liquidity


• Treasury Bills • Municipal Bonds and
• Fed Funds Sold to Notes
Other Banks • Federal Agency
• Purchasing Securities Securities
for Resale (Repos) • Negotiable Certificates
• Deposits with of Deposits
Correspondent Banks • Eurocurrency Loans

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Asset Liquidity Management is Not


Costless and Include Opportunity Cost:

• Loss of Future Earnings on Assets That Must


Be Sold
• Transaction Costs (Commissions) on Assets
That Must Be Sold
• Potential Capital Losses If Interest Rates are
Rising
• May Weaken Appearance of Balance Sheet
• Liquid Assets Generally Have Low Returns

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Borrowed Liquidity (Liability)


Management

This Strategy Calls for the Bank to


Purchase or Borrow from the
Money Market To Cover All of Its
Liquidity Needs

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Sources of Borrowed Funds

• Federal Funds Purchased


• Selling Securities for Repurchase (Repos)
• Issuing Large CDs (Greater than $100,000)
• Issuing Eurocurrency Deposits
• Securing Advance from the Federal Home
Loan Bank
• Borrowing Reserves from the Discount
Window of the Federal Reserve

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Borrowed Liquidity (Liability)


Management Strategy
Advantages Disadvantages

• Borrow Only When There • Highest Expected Return


is a Need for Funds But Carries the Highest
• Volume and Composition Risk Due to Volatility of
of the Investment Interest Rates and Possible
Portfolio Can Remain Rapid Changes in Credit
Unchanged Availability
• The Institution Can • Borrowing Cost is Always
Control Interest Rates in Uncertain-> Uncertain
Order to Borrow Funds Earnings
(raise offer rates when • Borrowing Needs Can Be
needs requisite amounts Interpreted as a Signal of
of funds)
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Balanced Liquidity Management


Strategy

The Combined Use of Liquid Asset


Holdings (Asset Management) and
Borrowed Liquidity (Liability
Management) to Meet Liquidity
Needs

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Guidelines for Liquidity Managers


• They Should Keep Track of All Fund-
Using and Fund-Raising Departments
• They Should Know in Advance
Withdrawals by the Biggest Credit or
Deposit Customers
• Their Priorities and Objectives for
Liquidity Management Should be Clear
• Liquidity Needs Must be Evaluated on a
Continuing Basis
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Methods for Estimating Liquidity


Needs
• Sources and Uses of Funds Approach

• Structure of Funds Approach

• Liquidity Indicator Approach

• Signals from the Marketplace

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Sources and Uses of Funds


• Loans and Deposits Must Be Forecast for a
Given Liquidity Planning Period
• The Estimated Change in Loans and
Deposits Must Be Calculated for the Same
Planning Period
• The Liquidity Manager Must Estimate the
Bank’s Net Liquid Funds By Comparing the
Estimated Change in Loans to the Estimated
Change in Deposits

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Structure of Funds Approach


• A Bank’s Deposits and Other Sources of
Funds Divided Into Categories. For
Example:
▫ ‘Hot Money’ Liabilities (volatile liabilities)
▫ Vulnerable Funds
▫ Stable Funds (core deposits or core liabilities)
• Liquidity Manager Set Aside Liquid Funds
According to Some Operating Rule

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Customer Relationship Doctrine

Management Should Strive to Meet All


Good Loans that Walk in the Door in
Order to Build Lasting Customer
Relationships

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Liquidity Indicator Approach


(Based on Experience and Industry Averages)
• Cash Position Indicator • Hot Money Ratio

• Liquid Security Indicator • Deposit Brokerage Index

• Net Federal Funds Position • Core Deposit Ratio

• Capacity Ratio • Deposit Composition Ratio

• Pledged Securities Ratio • Loan Commitment Ratio

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The Ultimate Standard: Market


Signals of Liquidity Management
• Public Confidence

• Stock Price Behavior

• Risk Premiums on CDs

• Loss Sales of Assets

• Meeting Commitments to Creditors

• Borrowings from the Central Bank


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Legal Reserves

• Assets That a Central Bank Requires


Depository Institutions to Hold as a
Reserve Behind Their Deposits or
Other Liabilities

• Only 2 Kinds of Assets Can Be Used


for This Purpose: 1) Cash in the Vault;
2) Deposits Held in a Reserve Account
With the Regional Fed.
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U.S. Legal Reserve Requirements


• In 2007-2008, first $9.3 Million have 0 Legal
Reserves
• 3 Percent of End-of-the-Day Daily Average for
a Two Week Period For Transaction Accounts
Up To $43.9 Million ($43.9 million is known as
the reserve tranche and changes every year)
• 10 Percent of End-of-the-Day Daily Average
for a Two Week Period For Transaction
Accounts For Amounts Over $43.9 Million
• Transaction Accounts Include Checking
Accounts, NOW Accounts and Other Deposits
Used to Make Payments
• The $43.9 Million Amount is Adjusted Annually
• The Money Position Manager Oversees the
Institution’s Legal Reserve Account

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Calculating Required Reserves

Any deficit above 4% may be assessed an interest penalty equal to the Federal
Reserve’s discount (primary credit) rate at the beginning of the month plus 2
percentage points applied to the amount of the deficiency.
Repeated reserve deficits lead to increased regulatory scrutiny, possibly damaging its
efficiency.
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Factors Influencing the Money Position

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Sweep Account
• Volume of Legal Reserves Held at the Fed
Has Declined in Recent Years Largely Due to
Sweep Accounts

• A Contractual Account Between Bank and


Customer that Permits the Bank to Move
Funds Out of a Customer’s Checking
Account Overnight in Order to Generate
Higher Returns for the Customer and Lower
Reserve Requirements for the Bank
▫ Retail Sweep
▫ Business Sweep
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Other Factors to Influence Legal


Reserves
• Use of Fed Funds Market
▫ The cheapest source
▫ But very volatile
▫ Managers rely on the Fed funds target rate (the
most volatile on the settlement date)
• Other Options
▫ Sell liquid securities
▫ Draw upon excess correspondent balances
▫ Enter into repurchase agreements for temporary
borrowings
▫ Sell new time deposits
▫ And borrow in the Eurocurrency market
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Factors in Choosing Among Different


Sources of Reserves
• Immediacy of Bank’s Needs

• Duration of Bank’s Needs

• Bank’s Access to Market for Liquid Funds

• Relative Costs and Risks of Alternatives

• Interest Rate Outlook

• Outlook for Central Bank Monetary Policy

• Regulations Applicable for Liquidity Sources


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Quick Quiz
• What are the principal differences among asset
liquidity management, liability management,
and balanced liquidity management?
• What guidelines should management keep in
mind when it manages a financial firm’s
liquidity position?
• What is money position management?
• What is the principal goal of money position
management?
• What factors should a money position manager
consider in meeting a deficit in a depository
institution’s legal reserve account?
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Bank Management and Financial Services, 7/e
Chapter Twelve

Managing and Pricing Deposit


Services
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Key Topics
• Types of Deposit Accounts Offered

• The Changing Mix of Deposits and Deposit Costs

• Pricing Deposit Services and Deposit Interest Rates

• Conditional Deposit Pricing

• Rules for Deposit Insurance Coverage

• Disclosure of Deposit Terms

• Lifeline Banking

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Key Issues Depository Institutions Are


Faced With:
1. Where can funds be raised at lowest
possible cost?

2. How can management ensure that there


are enough deposits to support lending
and other services the public demands?

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Recent Trends

• Pricing Schedules and Competitive


Maneuverings of Other Financial Institutions
• Competitors: Mutual Funds, Credit Unions,
Cash Management Accounts at Brokerage
Firms and Insurance Companies, and
Interest-Bearing Investment Accounts
Offered by Securities Firms
• An Important Executive Position of the Chief
Deposit Officer
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Types of Deposit Accounts


• Transaction (Payment or Demand) Deposits
▫ Making Payment on Behalf of Customers
▫ One of The Oldest Services
▫ Provider is Required to Honor Any
Withdrawals Immediately
• Nontransaction (Savings or Thrift) Deposits
▫ Longer-Term
▫ Higher Interest Rates Than Transaction
Deposits
▫ Generally Less Costly to Process and Manage
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Transaction Deposit

An Account Used Primarily to Make


Payments for Purchases of Goods and
Services

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Types of Transaction Deposits


• Noninterest-Bearing Demand Deposits
▫ Interest Was Prohibited by Glass-Steagall Act
▫ One of the Most Volatile and Unpredictable
Sources of Funds
▫ Most Deposits are Held by Business Firms
• Interest-Bearing Demand Deposits
▫ Negotiable Orders of Withdrawal (NOW)-
hybrid savings instrument
▫ Money Market Deposit Account (MMDA) and
Super NOW due to Garn-St Germain
Depository Institution Act of 1982
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Nontransaction (Savings or Thrift)


Deposit

An Account Whose Primary Purpose is


to Encourage the Bank Customer to
Save Rather than Make Payments

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Types of Savings or Thrift Deposits


• Passbook Savings Account
• Statement Savings Deposit
• Time Deposit (CD)
• Individual Retirement Account (IRA) -
The Economic Recovery Tax Act of1981
• Keogh Deposit – have tax benefits
• Roth IRA – The Tax Relief Act of 1997
Allows Non-Tax-Deductible
Contributions
• Default Option Retirement Plans – The
Pension Protection Act of 2006

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Popular Types of CDs

• Bump-Up CD – Allows a Depositor to Switch


to a Higher Interest Rate if Market Rates
Rise
• Step-Up CD – Permits Periodic Upward
Adjustments in the Promised Interest Rate
• Liquid CD – Permits the Depositor to
Withdraw Some or All of Their Funds
Without a Withdrawal Penalty

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Interest Rates on Deposits Depend


On:
• The Maturity of the Deposit

• The Size of the Offering Institution

• The Risk of the Offering Institution

• Marketing Philosophy and Goals of the


Offering Institution

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The Changing Composition of Deposits in the US

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Core Deposits

A Stable Base of Funds that is Not


Highly Sensitive to Movements in
Market Interest Rates (Low Interest-
Rate Elasticity) and Which Tend to
Remain with the Bank

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Check 21 and Substitute Checks


• Effective October 28,2004 – Permits
Depository Institutions to Electronically
Transfer Check Images
• The Images are Called Substitute Checks
and is a Legal Copy of the Check
• Protects Depositors Against Loss
• Benefits Institutions by Reducing the Cost
of Check Clearing
• Substitute Checks Can Be Sent Electronically
Instead of Sending Bundles of Checks
• More Information:
http://www.federalreserve.gov/
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FDIC Insurance Coverage


• Banks Insured Through Bank Insurance Fund
(BIF)
• Savings and Loans Insured Through Savings
Association Insurance Fund (SAIF)
• Covers Only Those Deposits Payable in the
U.S.
• Many Types of Accounts are Covered Up To
$100,000 (increased to $250,000 until year-
end 2009 by the Emergency Economic
Stabilization Act of 2008) for Each Account
Holder within the Same Bank (Even if Different
Branches)
• Deposits Placed in Separate Institutions are
Insured Separately © 2008 The McGraw-Hill Companies, Inc., All Rights Reserved.
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Truth in Savings Act


• Consumers Must be Informed of the
Deposit Terms Before They a New Account
• Depository Institutions Must Disclose:
▫ Minimum Balance to Open
▫ Minimum to Avoid Fees
▫ How the Balance is Figured
▫ When Interest Begins to Accrue
▫ Penalties for Early Withdrawal
▫ Options at Maturity
▫ And the APY

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Pricing Deposit-Related Services

• The Glass-Steagall Act of 1933 – Federal


Limits on Interest Rates Paid on Deposits –
why?
• Nonprice Competition
• The Depository Institutions Deregulation
Act of 1980
▫ Cost-Plus Pricing
▫ Marginal Cost of Deposits
▫ Conditional Pricing
▫ Relationship Pricing
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Cost Plus Profit Deposit Pricing

Estimating
Unit Price Operating Planned
Overhead
Charged the Expense Profit from
Expense
Customer = Per Unit of + + Each
Allocated to
for Each Deposit Service Unit
the Deposit
Service Service Sold
Function

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The Marginal Cost Approach:


Historical Average Cost Approach

Determines the Bank’s Const of Funds by


Looking at the Past. It Looks at What Funds
the Bank Has Raised to Date and What those
Funds Have Cost

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Pooled Funds Approach

Determine the Bank’s Cost of Funds


by Looking at the Future. What
minimum Rate of Return is the Bank
Going to Have to Earn on Any Future
Loans and Securities to Cover the Cost
of all New Funds Raised?

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Using Marginal Cost to Set Interest


Rates on Deposits

Many Financial Analysts Would Argue


That the Added Cost (Not Weighted
Average Cost) of Bringing New Funds
into the Bank Should Be Used to Price
Deposits.

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Market Penetration Deposit Pricing

The Method of Selling Deposits That


Usually Sets Low Prices and Fees
Initially to Encourage Customers to
Open an Account and Then Raises
Prices and Fees Later On.

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Conditional Pricing
• Schedule of Fees were Low If Customer
Stayed Above Some Minimum Balance -
Fees Conditional On How the Account Was
Used
• Conditional Pricing Based On One or More
Of the Following Factors
▫ The Number of Transactions Passing Through the
Account
▫ The Average Balance Held in the Account During
the Period
▫ The Maturity of the Deposit
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Upscale Target Pricing


Bank Aggressively Goes After High-
Balance, Low-Activity Accounts. Bank
Uses Carefully Designed Advertising to
Target Established Business Owners
and Managers and Other High Income
Households.

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Relationship Pricing

The Bank Prices Deposits According to


the Number of Services Purchased or
Used. The Customer May Be Granted
Lower Fees or Have Some Fees Waived
If Two or More Services are Used.

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Basic or Lifeline Banking

Some People Feel That All Individuals


Are Entitled to a Minimum Level of
Financial Services No Matter Their
Income Level

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Quick Quiz
• What are the major types of deposit plans offered
today?
• What are core deposits, and why are they so
important?
• How has the composition of deposits changed in
recent years?
• A bank determines from an analysis of its cost-
accounting figures that for each $500 minimum-
balance checking account it sells, account
processing and other operating costs will average
$4.87 per month and overhead expenses will urn
an average of $1.21 per month. The bank hopes to
achieve a profit margin over these particular costs
of 10 percent of total monthly costs. What monthly
fee should it charge a customer who opens one of
these checking accounts?
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Quick Quiz (cont.)

• Suppose that a customer holds a savings


deposit in a savings bank for a year. The
balance in the account stood at $2000 for
180 days and $100 for the remaining days
in the year. If the savings bank paid this
depositor $8.50 in interest earnings for the
year, what APY did this customer receive?
(Use the formula required by the Truth in
Savings Act)
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Chapter Fifteen

The Management of Capital

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Key Topics
• The Many Tasks of Capital

• Capital and Risk Exposures

• Types of Capital In Use

• Capital as the Centerpiece of Regulation

• Basel I and Basel II

• Planning to Meet Capital Needs


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Tasks Performed By Capital


• Provides a Cushion Against Risk of
Failure
• Provides Funds to Help Institutions Get
Started
• Promotes Public Confidence (credit crisis
2007-2009 showed importance)
• Provides Funds for Growth
• Regulator of Growth
• Role in Growth of Bank Mergers
• Regulatory Tool to Limit Risk Exposure
• Protects the Government’s Deposit
Insurance System
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Key Risks in Financial Institutions


Management
• Credit Risk
▫ Probability of default on any promised payments of
interest or principal or both
• Liquidity Risk
▫ Probability of being unable to raise cash when needed
at reasonable cost
• Interest Rate Risk
▫ Probability that changes in interest rates will
adversely affect the value of net worth
• Operational Risk
▫ Probability of adverse affect of earnings due to
failures in computer systems, management errors,
etc.
• Exchange Risk
▫ Probability of loss due to fluctuating currency prices
• Crime Risk
▫ Due to embezzlement, robbery,
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Defenses Against Risk


• Quality Management
• Diversification
▫ Geographic
▫ Portfolio
• Deposit Insurance (increased from
$100K to $250K in the Fall of 2008
through Dec 2009)
• Owners’ Capital

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Types of Capital

• Common Stock • Subordinated


• Preferred Stock Debentures
• Surplus • Minority Interest
in Consolidated
• Undivided Profits Subsidiaries
• Equity Reserves • Equity
Commitment
Notes

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Relative Importance of Different Sources of


Capital

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Reasons for Capital Regulation


The underlying assumption is that the
private marketplace does not correctly price
the impact of systemic failures. Thus, the
purpose of capital regulation is:

• To Limit the Risk of Failures


• To Preserve Public Confidence
• To Limit Losses to the Federal Government
Arising from Deposit Insurance Claims

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The Basel Agreement on International


Capital Standards
An International Treaty Involving the
U.S., Canada, Japan and the Nations of
Western Europe to Impose Common
Capital Requirements On All Banks
Based in Those Countries

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Quick Quiz
• What forms of capital are in use today? What
are the key differences between the different
types of capital?
• What are the most important and least
important forms of capital held by U.S.-insured
banks? How do small banks differ from large
banks in the composition of their capital
accounts and in the total volume of capital they
hold relative to their assets?
• What is the rationale for having the government
set capital standards for financial institutions
as opposed to letting the private marketplace
set those standards?
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The Basel Agreement


• Historically, the minimum capital requirements
for banks were independent of the riskiness of
the bank
▫ Prior to 1990, banks were required to maintain:
 a primary capital-to-asset ratio of at least 5% to 6%,
and
 a minimum total capital-to-asset ratio of 6%
• The Basel Agreement of 1988 includes risk-
based capital standards for banks in 12
industrialized nations; designed to:
▫ Encourage banks to keep their capital positions
strong
▫ Reduce inequalities in capital requirements
between countries
▫ Promote fair competition
▫ Account for financial innovations (OBS, etc.)
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The Basel Agreement


• A Bank’s Minimum Capital Requirement is
Linked to its Credit Risk
▫ The greater the credit risk, the greater the
required capital
• Stockholders' equity is deemed to be the most
valuable type of capital
• Minimum capital requirement increased to 8%
total capital to risk-adjusted assets
• Capital requirements were approximately
standardized between countries to ‘level the
playing field‘
• Capital is divided into Two Tiers
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Tier 1 Capital
• Common Stock and Surplus
• Undivided Profits
• Qualifying Noncumulative Preferred Stock
• Minority Interests in the Equity Accounts of
Consolidated Subsidiaries
• Selected Identifiable Intangible Assets Less
Goodwill and Other Intangible Assets

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Tier 2 Capital
• Allowance for Loan and Lease Losses
• Subordinated Debt Capital Instruments
• Mandatory Convertible Debt
• Cumulative Perpetual Preferred Stock with
Unpaid Dividends
• Equity Notes
• Other Long Term Capital Instruments that
Combine Debt and Equity Features

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Basel Agreement Capital Requirements

• Ratio of Core Capital (Tier 1) to Risk


Weighted Assets Must Be At Least 4 Percent
• Ratio of Total Capital (Tier 1 and Tier 2) to
Risk Weighted Assets Must Be At Least 8
Percent
• The Amount of Tier 2 Capital Limited to 100
Percent of Tier 1 Capital

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Calculating Risk-Weighted Assets

• Compute Credit-Equivalent Amount of Each


Off-Balance Sheet (OBS) Item
• Find the Appropriate Risk-Weight Category for
Each Balance Sheet and OBS Item
• Multiply Each Balance Sheet and Credit-
Equivalent OBS Item By the Correct Risk-Weight
• Add to Find the Total Amount of Risk-Weighted
Assets
• See BHC’s Call report and RBC calculations:
https://cdr.ffiec.gov/public/ManageFacsimiles.
aspx

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Total Regulatory Capital Calculations

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What Was Left Out of the Original Basel


Agreement
• The Most Glaring Hole with the Original Basel
Agreement is its Failure to Deal with Market Risk,
Especially Problematic During the 2007-2009 Global
Credit Crisis
• In 1995 the Basel Committee Announced New Market
Risk Capital Requirements for Their Banks
• In the U.S. Banks Can Create Their Own In-House
Models to Measure Their Market Risk Exposure, VaR,
to Determine the Maximum Amount a Bank Might
Lose Over a Specific Time Period
• Regulators Would Then Determine the Amount of
Capital Required Based Upon Their Estimate
• Banks That Continuously Estimate Their Market Risk
Poorly Would Be Required to Hold Extra Capital
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Value at Risk (VAR) Models

A Statistical Framework for Measuring


a Bank Portfolio’s Exposure to
Changes in Market Prices or Market
Rates Over a Given Time Period
Subject to a Given Probability

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Central Elements of VaR


• An Estimate of the Maximum Loss in a Bank’s
Portfolio Value at a Specified Level of Risk Over
10 Business Days
• A Statement of the Confidence Level
Management Attaches to its Estimate of the
Probability of Loss
• An Estimate of the Time Period Over Which the
Assets in Question Could be Liquidated Should
the Market Deteriorate
• A Statement of the Historical Time Period
Management Uses to Help Develop Forecasts of
Market Value and Market Rates of Interest

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Basel II

• Aims to Correct the Weaknesses of Basle I


• Three Pillars of Basel II:
▫ Capital Requirements For Each Bank Are Based
on Their Own Estimated Risk Exposure from
Credit, Market and Operational Risks
▫ Supervisory Review of Each Bank’s Risk
Assessment Procedures and the Adequacy of
Its Capital
▫ Greater Disclosure of Each Bank’s True
Financial Condition

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Credit Risk Models

• Parallel the Development of VaR Models


• IF Adverse Situation Develops in the Future,
What Magnitude of Losses Can Be Expected?
• Model Generates Risk Estimates Based On
▫ Borrower Credit Rating
▫ Probability Credit Rating Will Change
▫ Probable Amount of Recovery
▫ The Possibility of Changing Interest Rate Spreads

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Revised Framework for Basel II

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Capital Adequacy Categories Based


on Prompt Corrective Action (PCA)

• Well Capitalized
• Adequately Capitalized
• Undercapitalized
• Significantly Undercapitalized
• Critically Undercapitalized

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Internal Capital Growth Rate


= ROE X Retention Ratio

= Profit Margin X Asset Utilization


X Equity Multiplier X Retention
Ratio

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Planning to Meet a Bank’s Capital


Needs
• Raising Capital Internally
▫ Dividend Policy
▫ Internal Capital Growth Rate
• Raising Capital Externally
▫ Issuing Common Stock
▫ Issuing Preferred Stock
▫ Issuing Subordinated Notes and Debentures
▫ Selling Assets and Leasing Facilities
▫ Swapping Stock for Debt Securities
▫ Choosing the Best Alternative

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Quick Quiz
• What are the most popular financial ratios
regulators use to assess the adequacy of bank
capital today?
• First National Bank reports the following items
on its balance sheet: cash, $200m; U.S.
government securities, $150m; residential real
estate loans, $300m; and corporate loans,
$350m. Its off-balance sheet items include
standby credit letters, $20m, and long-term
credit commitments to corporations, $160m.
What are First Nation’s total risk-weighted
assets? If the bank reports Tier 1 capital of
$30m and Tier 2 capital of $20m, does it have
a capital deficiency?
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