Accounting Fundamentals for Financial Institutions Midterm

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15 short answers, 10 multiple choices, and 7 true and false questions.

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Asset

and Liability Management

Mid Term 2020

Name:

Written Response Short Answer Questions (75 points):

Responses should be short and concise approximately 5-6 sentences, though some questions may take more space to cover adequately.

1. Identify and briefly explain the five risks common to financial institutions.

2. What were some of the causes of the Great Recession of 2008?

3. What is a subprime lender? Do they operate differently compared to other lenders?

4. Why would a manufacturing company create its own financial services company?

5. What is the adverse selection problem? How does adverse selection affect the profitable management of an insurance company?

6. Describe the Initial Public Offering process.

7. What is factoring? Why do companies factor?

8. The banking acts of the 1930s are considered landmark legislation in US Banking history. What did these laws do? What problems were they meant to solve?

9. How do Financial Institutions solve the information and related agency costs when household savers invest directly in securities issued by corporations? What are agency costs?

10. What is the primary function of an insurance company? How does this function compare with the primary function of a depository institution?

11. During the 1999’s The Financial Services Modernization Act of 1999 was enacted. What did this law do? What were some of the consequences for the US banking system?

12. What are three key activity areas for securities firms?

13. What is negative externality? In what ways do the existence of negative externalities justify the extra regulatory attention received by financial institutions?

14. a. Suppose a 65-year-old person wants to purchase an annuity from an insurance company that would pay $20,000 per year until the end of that person’s life. The insurance company expects this person to live for 15 more years and would be willing to pay 6 percent on the annuity. How much should the insurance company ask this person to pay for the annuity?

b. A second 65-year-old person wants the same $20,000 annuity, but this person is much healthier and is expected to live for 20 years. If the same 6 percent interest rate applies, how much should this healthier person be charged for the annuity?

Multiple Choice (15 points)

1. Safety and soundness regulations include all of the following layers of protection EXCEPT

a) the provision of guarantee funds.

b) requirements encouraging diversification of assets.

c) the creation of money for those FIs in financial trouble.

d) requiring minimum levels of capital.

e) monitoring and surveillance.

2. Which of the following would be a key area of activity for an investment bank specializing in the commercial side of the business?

a) Purchase of existing securities.

b) Sale of securities in the secondary market.

c) Brokerage of existing securities.

d) Underwriting issues of new securities.

e) All of these.

3. Which of the following is NOT true?

a) The finance company industry tends to be very concentrated.

b) Twenty of the largest finance companies account for more than 65% of the industry assets.

c) Many of the largest finance companies tend to be wholly owned or are captive subsidiaries of major manufacturing firms.

d) Finance companies specialize only in consumer loans and do not make business loans.

e) Finance companies often provide captive financing for the purchase of products manufactured by their parent company.

4. A coupon bond that pays interest annually has a par value of $1,000, matures in seven years, and has a yield to maturity of 9.3%. The current price of the bond today will be ______ if the coupon rate is 8.5%.

a) $712.99

b) $960.14

c) $1,123.01

d) $886.28

e) $1,000.00

5. The primary function of insurance companies is to

a) generate fees for the banks that sell insurance products.

b) sell a variety of consumer investment products.

c) protect policyholders from adverse events.

d) assist in the transfer of wealth into the future.

e) provide contracts that encourage policyholders to save current income.

6. An investment banker agrees to underwrite an issue of 10 million shares of stock for TWResearch, Inc. on a firm commitment basis. The investment banker pays $10.50 per share to TWResearch, Inc. for the 10 million shares of stock. It then sells those shares to the public for $11.20 per share.

If the investment bank can sell the shares for $9.75 per share, what is the profit (loss) to the investment banker?

a) Profit of $1,000,000.

b) Loss of $7,500,000.

c) Profit of $7,000,000.

d) Loss of $7,000,000.

e) Loss of $1,000,000.

7. What is the primary function of finance companies?

a) Protect individuals and corporations from adverse events.

b) Make loans to both individuals and corporations.

c) Extend loans to banks and other financial institutions.

d) Pool the financial resources of individuals and companies and invest in diversified portfolios of assets.

e) Assist in the trading of securities in the secondary markets.

8. All else equal, the price and yield on a bond are

a) positively related.

b) negatively related.

c) sometimes positively and sometimes negatively related.

d) not related.

e) indefinitely related.

9. A college professor is looking to retire in 30 years with $1,000,000. Currently, she has no savings. She believes she can earn 7% on money she saves during this time. Is she starts now, how much will she need to have saved at the end of each to reach her goal?

a) $11448.65

b) $10586.40

c) $11327.45

d) $9839.83

e) $33,333.33

10. A zero coupon bond with a face value of $1000 is for sale on the market. If the bond matures in 5 years and the current interest rate is 2%. What is the most you should pay for the bond?

a) $905.73

b) $923.84

c) $887.97

d) $1000

e) $883.85

Truth/False (10 points)

1. Commercial banks and finance companies have traditionally served the needs of the residential real estate market.

a) True

b) False

2. In recent years, the number of banks in United States has been increasing.

a) True
b) False

3. The movement of an off-balance-sheet asset or liability to an on-balance-sheet item is dependent on the occurrence of a contingent event.

a) True
b) False

4. Market making involves creating a primary market in a financial asset.

a) True
b) False

5. The securitization of mortgages involves the pooling of mortgage loans for sale in the financial markets.

a) True
b) False

6. Because of the large amount of equity on a typical commercial bank balance sheet, credit risk is not a significant risk to bank managers.

a) True
b) False

7. The ability of diversification to eliminate much of the risk from the asset side of the balance sheet of an FI is the result of choosing assets that are less than perfectly positively correlated.

a) True
b) False

>Duration

Coupon

.00%

Face value

2 Frequency 2

Maturity 5

Yield 9.00%

Price

1.755

.590

Macaulay Dur

Modified Dur

Dollar Dur 3.956

										DURATION
BOND A	BOND B
	Coupon	6.			5			0	9
	Face value				1	100
	Frequency
	Maturity						4
		Yield	6.00%
			Price	10	1.755	100.000
Difference, A&B
	Macaulay Dur			3	4.134
	Modified Dur	3.4	8		3.956
	Dollar Dur			3.5
Ian Giddy

&A
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Duration – The Long Way

Yield

3 3.5 4

4 4 4

0 0 0 0 0 0

Price 100

4 8

0 0 0 0 0 0

3.8461538462

0 0 0 0 0 0

Time (year) 0.5 1 1.5 2 2.5 3 3.5 4 4.5 5

Cash-Flows 4.5 4.5 4.5 4.5 4.5 4.5 4.5 4.5 4.5

PV of CFs

8596

Price

Weighted CFs 4.5 9

PV of weighted CFs 4.3269230769

Sum of weight. CFs

Semiannual duration

Macaulay duration is 1.8875455166

Macaulay duration is

With a yield of 8.00%

Bond A’s

Bond B’s Modified duration is

With a yield of 8.00%

Bond A’s

Bond B’s Dollar duration is

DURATION, THE LONG WAY
MACAULAY DURATION
0.08
Bond A		Time (year)		0.5		1.5		2.5					4.5
	Cash-Flows	104
	PV of CFs		3.8461538462	3.6982248521	3.5559854347	88.8996358671
	Weighted CFs	12	416
	PV of weighted CFs	7.3964497041	10.6679563041	355.5985434684
	Sum of weight. CFs	377.50910332	27
	Semiannual duration	3.7750910332
		Macaulay duration is		1.8875455166
Bond B
104.5
	4.3269230769	4.1605029586	4.00048	36	3.8466	18	3.6986719804	3.5564153658	3.4196301594	3.2881059225	3.1616403101	70.5964556423
104.0554478897
13.5	22.5	31.5	40.5	1045
8.3210059172	12.0014508421	15.3864754385	18.4933599021	21.3384921947	23.9374111159	26.3048473801	28.4547627909	705.964556423
864.5292850813
8.3083519663
		With a yield of			8.00%
		Bond A’s
		Bond B’s	4.1541759832
MODIFIED DURATION (Same inputs as Macaulay’s).
	Modified duration is	1.8149476121
3.9943999838
DOLLAR DURATION (Same inputs as Macaulay’s)
	Dollar duration is	181.4947612128
415.639079366

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FI 201
Investment Banking

The Role of Investment Bankers
Middleman who brings together investors and firms (and governments) issuing new securities.

Initial Public Offering (IPO) – First sale of common stock to the general public.

The Role of Investment Bankers
Underwriting – Purchase of an issue of new securities for subsequent sale by investment bankers; the guaranteeing of the sale of a new issue of securities.
Originating House – Investment banker who makes an agreement to sell a new issue and forms a syndicate to sell securities.

The Role of Investment Bankers
Syndicate – Selling group formed to market a new issue of securities

Best efforts agreement – Contract with an investment banker for the sale of securities in which the investment banker does not guarantee the sale but does agree to make the best effort to sell the securities

The pricing of new issues is crucial.
If the initial offer price is too high, the syndicate will be unable sell the securities.
When this occurs the investment banker has two choices:
1) to maintain the offer price and to hold the
securities in inventory until they are sold, or
2) to let the market find a lower price level that
will induce investors to purchase the
securities.
Neither choice benefits the investment bankers

Pricing a New Issue

Marketing New Securities
Preliminary prospectus (red herring) – Initial document detailing the financial condition of a firm that must be filed with the SEC to register a new issue of securities.
Securities Exchange Commission (SEC) – Government agency that enforces the federal securities laws.
Registration – The process of filing information with the SEC concerning a proposed sale of securities to the general public.

A nonpublic sale of securities to a financial institution such as an endowment fund, mutual fund or pension fund.

Private Placements

Regulation- Full Disclosure Laws
Securities Act of 1933 – covers new issue of securities
Securities Exchange Act of 1934 – devoted to trading in existing securities
10-K Report – Required annual report filed with the SEC by publicly-held firms.
Securities Investor Protection Corporation (SIPC) – Federal agency that insures investors against failures by brokerage firms – limited to $500,000 per customer.

The independence of auditors and the creation of the Public Company Accounting Oversight Board

Corporate responsibility and financial disclosure

Conflict of interest and corporate fraud and accountability
Sarbanes-Oxley Act of 2002

Asset and Liability Management

Fin6102

Ferriter – Spring 2018

Overview
This chapter discusses the risks faced by financial institutions:
Interest rate risk, market risk, credit risk, off-balance-sheet risk, foreign exchange risk, country or sovereign risk, technology and operational risk, liquidity risk, and insolvency risk
Note: These risks are not unique to FIs
Faced by all global firms
Ch 7-2
©McGraw-Hill Education.

Risks of Financial Intermediation
Interest rate risk results from mismatch in asset and liability maturities:
Spread changes as interest rates change
Since value = PV(Cash flows), equity affected
Balance sheet hedge via matching maturities of assets and liabilities is problematic for FIs
Inconsistent with active asset transformation function
Reinvestment/refinancing
Market value risks
Ch 7-3
©McGraw-Hill Education.

Credit Risk
Risk that promised cash flows will not be paid in full
High rate of charge-offs of debt in the 1980s, most of the 1990s, and 2000s
Charge-offs continued to grow until late 2008
Firm-specific credit risk
Systematic credit risk
Ch 7-4
©McGraw-Hill Education.

Ch 7-5
Charge-Off Rates for Commercial Banks
©McGraw-Hill Education.

5
5

Implications of Growing Credit Risk
Importance of credit screening and monitoring
Diversification of credit risk
Loan sales, reschedulings, good bank-bad bank structure
Credit derivatives
Ch 7-6
©McGraw-Hill Education.

Liquidity Risk
Risk of being forced to borrow or sell assets in a very short period of time
Low prices result
May generate runs
Runs may turn a liquidity problem into a solvency problem
Failure of IndyMac in summer of 2008
Ch 7-7
©McGraw-Hill Education.

Foreign Exchange Risk
FI may be net long or net short in various currencies
Returns on foreign and domestic investments are not perfectly correlated
Technological and economical differences
FX rates may not be correlated
Example: $/€ may be appreciating while $/¥ falling
Undiversified foreign exposure creates FX risk
Ch 7-8
©McGraw-Hill Education.

Note that fully hedging foreign exposure by matching foreign assets and liabilities requires matching the maturities, as well*
Otherwise, exposure to foreign interest rate risk remains
* More specifically, FI must match durations, rather than simple maturities. See Chapter 9.
Ch 7-9
Foreign Exchange Risk Continued
©McGraw-Hill Education.

Country or Sovereign Risk
Risk that foreign borrowers may be unable to repay due to interference from foreign governments
Type of credit risk
Often lack usual recourse via court system
Example:
Argentina
Ch 7-10
©McGraw-Hill Education.

In the event of restrictions, reschedulings, or outright prohibition of repayments, a FI’s remaining bargaining chip is future supply of loans
Weak position if currency collapsing or government failing
Ch 7-11
Country or Sovereign Risk Continued
©McGraw-Hill Education.

Market Risk
Incremental risk incurred by FI when interest rate, FX, and credit risks are combined with an active trading strategy
Short trading horizons
Financial crisis of 2008-2009
Mortgage-backed securities
“Toxic” assets
Lehman Brothers, Merrill Lynch, AIG
Ch 7-12
©McGraw-Hill Education.

Market Risk Continued
Present whenever a FI takes an open or unhedged long (buy) or sell (short) position in securities, FX, or derivative products, and prices change in a direction opposite to expectation
Implications for regulators and management:
Need for controls
Need for measurement of risk exposure
Ch 7-13
©McGraw-Hill Education.

Off-Balance-Sheet Risk
Striking growth of off-balance-sheet activities
Letter of credit
Loan commitments
Derivative securities
Contingent assets and liabilities
Direct impact on future profitability and performance of FI
Ch 7-14
©McGraw-Hill Education.

Technology and Operational Risk
Risk of loss resulting from inadequate or failed internal processes, people and systems, or from external events
Target hacking incident in 2013
Heartland Payment Systems
“the London Whale”
Operational risk includes technology risk
Ch 7-15
©McGraw-Hill Education.

Technology Risk
Technological innovation has seen rapid growth
Automated clearing houses (ACH)
CHIPS
Real time interconnection of global FIs via satellite systems
E.g., Citigroup
Ch 7-16
©McGraw-Hill Education.

Economies of scale
Economies of scope
Operational risk not exclusively the result of technological failure
Employee fraud and errors
Losses magnified since they may result in loss of reputation and future business
Ch 7-17
Technology and Operational Risk Continued
©McGraw-Hill Education.

Insolvency Risk
Risk of insufficient capital to offset sudden decline in value of assets relative to liabilities
Original cause may be excessive interest rate, market, credit, off-balance-sheet, technology, FX, sovereign, and liquidity risks
Washington Mutual
“Too big to fail” (e.g., Citigroup)
Ch 7-18
©McGraw-Hill Education.

Other Risks and the Interaction of Risks
Interdependencies among risks
Example: Interest rate, credit and off-balance-sheet risks
Example: Liquidity, interest rate and credit risks
Discrete risks
Examples include effects of war or terrorist acts, market crashes, theft, and malfeasance
Changes in regulatory policy
Ch 7-19
©McGraw-Hill Education.

Pertinent Websites
Bank for International Settlements
Federal Deposit Insurance Corporation
Ch 7-20
www.bis.org

www.fdic.gov

©McGraw-Hill Education.

Asset and Liability Management

Fin6102

Ferriter – Spring 2018

1-2
Why Study Financial Markets
and Institutions?
Markets and institutions are primary channels to allocate capital in our society
Proper capital allocation leads to growth in:
Societal wealth
Income
Economic opportunity
In this first part of class we will examine:
the structure of domestic and international markets
the flow of funds through domestic and international markets
an overview of the strategies used to manage risks faced by investors and savers

1-3
Primary versus Secondary Markets
Primary markets
markets in which users of funds (e.g., corporations and governments) raise funds by issuing financial instruments (e.g., stocks and bonds)
Secondary markets
markets where existing financial instruments are traded among investors (e.g., exchange traded: NYSE and over-the-counter: NASDAQ)

3
You might also wish to mention electronic communication networks or ECNs. ECNs allow direct electronic trading among buyers and sellers without a third party. Two former ECNs, BATS (formed in 2005) and DirectEdge (formed in 1998), merged in fall 2013, and applied to become an exchange. The combined entity makes them the number two stock market ahead of NASDAQ and behind NYSE. Together the two have about 270 employees. The NYSE and NASDAQ have far more! Sign of the times.
BATS Global Markets is a stock exchange based in Lenexa, Kansas, a suburb of Kansas City. BATS was founded in June 2005 as an Electronic Communication Network (ECN) and its name stands for Better Alternative Trading System.[2] (Trades stocks on BZX and options on BYX exchange.) (source BATS website)

1-4
Primary versus Secondary Markets

Without FIs
Ch 1-5
Corporations
(net borrowers)
Households
(net savers)

Cash
Equity and debt claims
©McGraw-Hill Education.

FIs’ Specialness
Without FIs: Low level of funds flow between households and corporations.
Monitoring costs
Economies of scale reduce costs for FIs to screen and monitor borrowers
Liquidity costs
Substantial price risk
Ch 1-6
©McGraw-Hill Education.

Functions of FIs
Brokerage function
Acting as an agent for savers:
e.g. Bank of America Merrill Lynch
Reduce transaction and information costs
Encourages higher rate of savings
Asset-transformation
Issue more attractive financial claims to household savers
Finance the purchase of primary securities by selling financial claims to household investors and others
Ch 1-7
©McGraw-Hill Education.

With FIs
Ch 1-8
Cash
Households
Corporations
Equity and debt
FI
(brokers)
FI
(asset transformers)

Deposits and insurance policies
Cash
©McGraw-Hill Education.

Role of FIs in Cost Reduction
Information costs:
Investors exposed to Agency Costs
Role of FI as Delegated Monitor
FI likely to have greater incentive to monitor
Economies of scale in obtaining information
FI as an information producer
New secondary securities may enable FIs to monitor more effectively (e.g., bank loans)
Short-term contracts allow more control and monitoring power for FIs
Reduction of information asymmetry
Ch 1-9
©McGraw-Hill Education.

Specialness of FIs
Liquidity and Price Risk
Secondary claims issued by FIs have less price risk
Demand deposits and other claims are more liquid
More attractive to small investors
FIs have advantage over households in diversifying risks due to size
Ch 1-10
©McGraw-Hill Education.

10
10
The S&L debacle of 1980s was linked to inadequate diversification of S&Ls, especially in the oil based economies of the Southwest.

Other Special Services
Reduced transactions costs
Maturity intermediation
Transmission of monetary policy
Credit allocation (areas of special need such as home mortgages)
Intergenerational transfers or time intermediation
Payment services (FedWire and CHIPS)
Denomination intermediation
Ch 1-11
©McGraw-Hill Education.

11
11
Agriculture, small businesses, and home ownership in particular, have received special treatment in terms of loan subsidies and guarantees and other liquidity improving activities.
One of the key impediments to allowing non-FIs to act as banks, has been the fear of allowing non-FIs to gain access to the payment system. The arguments remain compelling even though some non-FIs have made inroads into the traditional business lines of banks in particular. Protection of the payment system is paramount, in terms of the role of FI regulators.

Specialness and Regulation
FIs receive special regulatory attention
Reasons:
Negative externalities of FI failure
Special services provided by FIs
Institution-specific functions such as money supply transmission (banks), credit allocation (thrifts, farm banks), payment services (banks, thrifts), etc.
Ch 1-12
©McGraw-Hill Education.

12
12

1-13
Primary versus Secondary Markets
How were primary markets affected by the financial crisis?
Do secondary markets add value to society or are they simply a legalized form of gambling?
How does the existence of secondary markets affect primary markets?

13
Primary market issuance declined sharply during the crisis although with low interest rates bond issuance boomed after market uncertainty declined in 2010. Stock issuance remained weaker longer, recovering in 2012 and 2013.
Secondary markets add liquidity for risky investments and encourage investment in primary markets. Secondary markets also aid in price discovery, providing up to date signals of the ongoing value of firms. These signals also provide benchmarks for corporate performance. It is not true that secondary markets are simply a legalized form of gambling.

1-14
Money versus Capital Markets
Money markets
markets that trade debt securities with maturities of one year or less (e.g., CDs and U.S. Treasury bills)
little or no risk of capital loss, but low return
Capital markets
markets that trade debt (bonds) and equity (stock) instruments with maturities of more than one year
substantial risk of capital loss, but higher promised return
Figure 1.3

1-15
Foreign Exchange (FX) Markets
FX markets
trading one currency for another (e.g., dollar for yen)
Spot FX
the immediate exchange of currencies at current exchange rates
Forward FX
the exchange of currencies in the future on a specific date and at a pre-specified exchange rate

15
Spot FX: Note that ‘immediate’ usually means delivery within one or two business days.

1-16
Derivative Security Markets
Derivative security
a financial security whose payoff is linked to (i.e., “derived” from) another security or commodity,
generally an agreement to exchange a standard quantity of assets at a set price on a specific date in the future,
the main purpose of the derivatives markets is to transfer risk between market participants.

1-17
Derivative Security Markets
Selected examples of derivative securities
Exchange listed derivatives
Many options, futures contracts
Over the counter derivatives
Forward contracts
Forward rate agreements
Swaps
Securitized loans

17
Exchange listed are more regulated, more transparent, and generally involve no default risk for the counterparty.
OTC derivatives are nonstandard, largely unregulated and may involve substantial counterparty credit risk.
Forward rate agreements are prearranged loan contracts with the loan terms set now, drawdowns in the future.

Regulation of FIs
Important features of regulatory policy:
Protect ultimate sources and users of savings
Including prevention of unfair practices such as redlining and other discriminatory actions
Primary role:
Ensure soundness of the overall system
Ch 1-18
©McGraw-Hill Education.

Safety and Soundness Regulation
Protect against the risk of FI failure:
Diversification of assets
No more than 5 percent of equity to single borrower
Minimum capital requirements
TARP and Capital Purchase Program
Guaranty funds:
Deposit Insurance Fund (DIF):
Securities Investors Protection Corporation (SIPC)
Ch 1-19
©McGraw-Hill Education.

Safety and Soundness Regulation Continued
Monitoring and surveillance:
Involves on-site examinations and review of accounting statements
FDIC monitors and regulates DIF participants
Increased regulatory scrutiny following crises
Regulation is not costless
Net regulatory burden

Ch 1-20
©McGraw-Hill Education.

1-21
Derivatives and the Crisis
Mortgage derivatives allowed a larger amount of mortgage credit to be created in the mid-2000s.
Growing importance of ‘shadow banking system’
Mortgage derivatives spread the risk of mortgages to a broader base of investors.
Change in banking from ‘originate and hold’ loans to ‘originate and sell’ loans.
Decline in underwriting standards on loans

21
(Optional slide: Hide if you do not wish to cover this topic)
This helped fuel a ‘credit boom’ that led to unsustainable increases in home prices. The shadow banking system refers to non-bank FIs who indirectly provide financing for loans buy originating loans or more likely by purchasing securities backed by loans. Shadow banking allows more rapid growth in credit by increasing the supply of funds available.
When home prices began falling in late 2006, more institutions were affected.
Resulted in a change in culture at some banks as well from a lending culture to a trading culture that was less risk averse.

The instructor may wish to ask students whether it makes sense to blame the instrument or the users. Warren Buffett has called derivatives, ‘weapons of mass destruction.’ However, used properly they allow market participants to transfer risk to other parties that they themselves do not wish to bear, and allow others lower cost methods to gain exposure to markets. It does seem reasonable to require greater transparency in OTC derivatives to ensure that players can cover the promises they make. Derivatives that involve payments of principal, such as credit default swaps, should be required to be traded on an exchange so that there are guarantees of performance and reasonable limits to speculation.

1-22
Derivatives and the Crisis
Subprime mortgage losses were large, reaching over $700 billion.
The “Great Recession” was the worst since the “Great Depression” of the 1930s.
Trillions $ global wealth lost, peak to trough stock prices fell over 50% in the U.S.
Lingering high unemployment and below trend growth in the U.S.
Sovereign debt levels in developed economies reached post-war all-time highs

22
(Optional slide: Hide if you do not wish to cover this topic)
Led to overall large declines in home prices nationwide. Houses are illiquid assets and falling home values are a drag on economic growth. Millions of homeowners are ‘underwater,’ owing more on their homes than their current market value.
Much of the wealth loss may be temporary over the long term, but growth declined at a rapid rate during the crisis. As of 2014 only now beginnin to see a return to more normal growth rates of the U.S. economy.

1-23
Financial Institutions (FIs)
Financial Institutions
institutions through which suppliers channel money to users of funds
Financial Institutions are distinguished by:
whether they accept insured deposits
depository versus non-depository financial institutions
whether they receive contractual payments from customers

23
Institutions that accept insured deposits must be regulated by the government to offset the government’s liability. Insured deposits are a low cost source of financing, but the regulatory burden increases these institution’s costs significantly.
FIs that receive contractual payments, such as life insurers, pension funds and property and casualty insurers have steady premium income to invest. This allows them to take on more risk in their investment portfolio.

1-24
Depository versus Non-Depository FIs
Depository institutions:
commercial banks, savings associations, savings banks, credit unions
Non-depository institutions
Contractual:
insurance companies, pension funds,
Non-contractual:
securities firms and investment banks, mutual funds.

24
Note: savings associations, savings banks and credit unions are often called ‘thrifts.’

1-25
Regulation of Financial Institutions
Dodd-Frank Bill
Promote robust supervision of FIs
Financial Service Oversight Council to identify and limit systemic risk,
Broader authority for Federal Reserve (Fed) to oversee non-bank FIs,
Higher equity capital requirements,
Registration of hedge funds and private equity funds.

1-26
Regulation of Financial Institutions
Dodd-Frank Bill
Comprehensive supervision of financial markets
New regulations for securitization and over the counter derivatives
Additional oversight by Fed of payment systems
Establishes a new Consumer Financial Protection Agency

1-27
Regulation of Financial Institutions
Dodd-Frank Bill
New methods to resolve non-bank financial crises
More oversight of Fed bailout decisions
Increase international capital standards and increased oversight of international operations of FIs.

27
Although a very small component of the personal lending market, person to person lending (P2P) is now growing rapidly as the regulatory burden of the Dodd-Frank bill has added significantly to the cost of banking. P2P lenders, such as Prosperity, are privately funded and are largely unregulated so they can often offer lower loan rates. This is an unintended effect of the law.

1-28
Risks Faced by Financial Institutions
Credit
Foreign exchange
Country or sovereign
Interest rate
Market
Off-balance-sheet
Liquidity
Technology
Operational
Insolvency
Volcker Rule: Insured institutions may not engage in proprietary trading

28
The Volcker Rule has not yet been fully implemented as of June 2014 and an extension has been granted for CLOs (collateralized loan obligations).

1-29
Globalization of Financial Markets and Institutions
The pool of savings from foreign investors is increasing and investors look to diversify globally now more than ever before,
Information on foreign markets and investments is becoming readily accessible and deregulation across the globe is allowing even greater access to foreign markets,
International mutual funds allow diversified foreign investment with low transactions costs,
Global capital flows are larger than ever.

Asset and Liability Management

Fin6102

Ferriter – Winter 2019

Overview
This chapter discusses finance companies
Services provided by finance companies
Competitive/financial environment
Size, structure, and composition
Regulation
Global issues
Ch 3-2
©McGraw-Hill Education.

Historical Perspective
First major finance company originated during the Great Depression
Installment credit
General Electric Capital Corporation
Competition from banks increased during 1950s
Expansion of product lines
GMAC
Ch 3-3
©McGraw-Hill Education.

GMAC
Controversial approval by the Fed of GMAC as a bank holding company in December 2008
Allowed access to $6 billion in government bailout money
Fed required GM to reduce its holdings in GMAC to less than 10 percent, from 49 percent
Ch 3-4
©McGraw-Hill Education.

Finance Companies
Activities similar to banks, but no depository function
May specialize in installment loans (e.g. automobile loans) or may be diversified, providing consumer loans and financing to corporations, especially through factoring
Commercial paper is key source of funds
Ch 3-5
©McGraw-Hill Education.

Finance Companies (continued)
Captive Finance Companies: e.g., Ford Motor Credit Corp.
Highly concentrated
Largest 20 firms: 65 percent of assets
Ch 3-6
©McGraw-Hill Education.

Major Types of Finance Companies
Sales finance institutions:
Ford Motor Credit and Sears Roebuck Acceptance Corp.
Personal credit institutions:
HSBC Finance and AIG American General
Business credit institutions:
CIT Group and U.S. Bancorp Equipment Finance
Equipment leasing and factoring
Ch 3-7
©McGraw-Hill Education.

Web Resources
For information on finance companies, visit:
GE www.ge.com
Ally www.ally.com
Ford Credit www.credit.ford.com
HSBC www.us.hsbc.com
Citigroup www.citigroup.com
Ch 3-8
©McGraw-Hill Education.

Ch 3-9
Largest Finance Companies
©McGraw-Hill Education.

Balance Sheet and Trends
Business and consumer loans are the major assets
61.2% of total assets, 2015
Reduced from 95.1% in 1977
Increases in real estate loans and other assets
Growth in leasing and business lending
Finance companies face credit risk, interest rate risk, and liquidity risk
Ch 3-10
©McGraw-Hill Education.

Consumer Loans
Consumer loans
Primarily motor vehicle loans and leases, other consumer loans, and securitized loans
Historically charged higher rates than for auto loans than commercial banks
Low auto finance company rates
Following 9/11 attacks
Attempts to boost new vehicle sales via 0.0% loans lasting into 2005
By 2002, finance company rates were more than 3% less than banks on new vehicles
Ch 3-11
©McGraw-Hill Education.

Consumer Loans (continued)
Generally attract riskier customers than commercial banks
Subprime lender finance companies
Jayhawk Acceptance Corp.
From auto loans to tummy tucks and hair transplants
“Loan shark” firms with rates as high as 30% or more
Ch 3-12
©McGraw-Hill Education.

12
Finance companies are more willing to offer mortgages to risky borrows than commercial banks because they aren’t regulated as stringently.

Payday Loans
Payday loans
390 percent APR
Regulated by states
As of 2015, payday lending effectively banned in 15 states
Controlled in other states via usury limits
Evaded bans by forming relationships with nationally chartered banks, based in states that do not have usury limits (e.g., South Dakota, Delaware)
Ch 3-13
©McGraw-Hill Education.

Mortgages
Mortgages have become a major component of finance company assets
Both residential and commercial
May be direct mortgages or securitized mortgage assets
Ch 3-14
©McGraw-Hill Education.

Home Equity Loans
Growth in home equity loans following passage of Tax Reform Act of 1986
Tax deductibility issue
Defaults in subprime and even relatively strong credit mortgages in 2007-2008
Root cause of the financial crisis of 2008-2009
Ch 3-15
©McGraw-Hill Education.

Web Resources
For information on home equity loans, visit:
Consumer Bankers Association www.cbanet.org

Ch 3-16
©McGraw-Hill Education.

Business Loans
Business loans comprise largest portion of finance company loans (28.5%)
Advantages over commercial banks:
Fewer regulatory impediments to types of products and services
Not depository institutions hence less regulatory scrutiny and lower overheads
Often have substantial expertise and greater willingness to accept riskier clients
Ch 3-17
©McGraw-Hill Education.

Business Loans Continued
Major subcategories:
Retail and wholesale motor vehicle loans and leases
Equipment loans
Tax and other associated advantages when finance company leases the equipment directly to the customer as opposed to financing the purchase
Other business loans and securitized business assets
Ch 3-18
©McGraw-Hill Education.

Liabilities
Major liabilities: Commercial paper and other debt (longer-term notes and bonds)
Finance firms are largest issuers of short-term commercial paper (frequently through direct sale programs)
Management of liquidity risk differs from commercial banks
Ch 3-19
©McGraw-Hill Education.

Industry Performance
Strong loan demand and solid profits for the largest firms in the early 2000s
Effects of low interest rates
Not surprisingly, the most successful became takeover targets
Citigroup/Associates First Capital
AIG/American General
HSBC Holdings/Household International
Ch 3-20
©McGraw-Hill Education.

Industry Performance Continued
Mid 2000s problems arose
2005, 2006: falling home prices and rising interest rates
Sharp pullback from subprime mortgage lending
End of 2009: National all time high for mortgage delinquencies 6.89%
Countrywide Financial and CIT Group failures
Ch 3-21
©McGraw-Hill Education.

Regulation of Finance Companies
Federal Reserve’s definition of finance company
A firm, other than a depository institution, whose primary assets are loans to individuals and businesses
Subject to state-imposed usury ceilings
Lower regulatory burden than DIs
Not subject to Community Reinvestment Act of 1977
Ch 3-22
©McGraw-Hill Education.

Impact of nonbank FIs, including finance companies, on the U.S. economy resulted in greater scrutiny
Fed rescue of several finance companies was a factor
2010 Wall Street Reform and Consumer Protection Act
Ch 3-23
Regulation of Finance Companies Continued
©McGraw-Hill Education.

Regulation Concluded
With less regulatory scrutiny, finance companies must signal safety and soundness to capital markets in order to obtain funds
Lower leverage than banks (12.8% capital-assets versus 11.3% for commercial banks in 2015)
Captive finance companies may employ default protection guarantees from parent company or other protection such as letters of credit
Ch 3-24
©McGraw-Hill Education.

Global Issues
In foreign countries, finance companies are generally subsidiaries of commercial banks or industrial firms
Importance of nonbank FIs has been increasing over the past decade
Latin America and Europe
New Zealand: consolidation, collapse, and restructuring of finance companies
Ch 3-25
©McGraw-Hill Education.

Pertinent Websites
American General
Federal Reserve
Consumer Bankers Association
Ford Motor Credit
General Electric Capital Corp.
Ally
HSBC Finance
Ch 3-26
www.aigag.com
www.federalreserve.gov
www.cbanet.org

www.credit.ford.com

www.gecapital.com

www.ally.com

www.us.hsbc.com
©McGraw-Hill Education.

Asset and Liability Management

Fin6102

Ferriter – Spring 2018

Overview
This chapter discusses mutual funds and hedge funds:
Activities of mutual funds
Size, structure, and composition
Balance sheets and recent trends
Regulation of mutual funds
Global issues
Activities of hedge funds
Regulation of hedge funds
Ch 5-2
©McGraw-Hill Education.

Mutual Funds
Diversification opportunities enhanced for small investors
Economies of scale
Predominantly open-ended funds
Ch 5-3
©McGraw-Hill Education.

Mutual Funds Continued
Rapid growth in funds during the 1990s
Slower rate of growth in the industry in early 2000s than in 1990s
Trading abuses and loss of confidence contributed to slowdown
20 percent drop in assets during 2008 financial crisis

Ch 5-4
©McGraw-Hill Education.

Mutual Funds Concluded
2015:
More than 7,600 stock and bond mutual companies
Total assets of $13.22 trillion
More than 8,100 firms and $15.94 trillion if money market mutual funds included
Ch 5-5
©McGraw-Hill Education.

Size, Structure, and Composition
First mutual fund: Boston, 1924
Slow industry growth, initially
Factors contributing to dramatic growth
Advent of money market mutual funds, 1972
Tax-exempt money market mutual funds, 1979
Special-purpose equity, bond, emerging market, and derivative funds
Ch 5-6
©McGraw-Hill Education.

Size, Structure, and Composition Continued
Total net assets in mutual funds:
1940: $0.5 billion
1990: $1,065.2 billion
2000: $6,964.6 billion
2007: $12,001.5 billion
2008: $9,603.6 billion
2009: $11,113.0 billion
2010: $11,831.9 billion
2012: $13,052.2 billion
2015: $15,944.6 billion
Ch 5-7
©McGraw-Hill Education.

Structure
Institutional funds
80 percent of retirement plan investments
Low costs
No additional distribution fees; bargaining power of retirement plan
Risk levels set by retirement plan sponsors
Low barriers to entry in US mutual fund industry
Allows new entrants to offer funds and compete for investors
Ch 5-8
©McGraw-Hill Education.

Size, Structure, and Composition Concluded
By asset size, mutual fund industry second most important FI group
Recent interest by commercial banks and insurance companies
Mellon purchase of Dreyfus
As of 2015, banks managed approximately 5% of mutual fund assets
State Farm (more than 9,000 agents)
As of 2015, insurance companies managed approximately 5% of mutual fund assets
Ch 5-9
©McGraw-Hill Education.

Ch 5-10
Assets of Major FIs: 1990, 2007, 2015
©McGraw-Hill Education.

10
10

Types of Mutual Funds
Types of long-term funds:
Bond funds, equity funds, hybrid funds
Volatility of long-term funds share:
74.3% of mutual fund assets, 1999
2002, long-term funds dropped to 62.1% of assets, losing ground to MMMFs
72.1% in 2007, 59.1% in 2008
68.1% in 2009, 77.4% in 2015
Ch 5-11
©McGraw-Hill Education.

Share of Long Term Funds
If MMMFs uninsured:
Higher returns
September 2008:
Risk aversion of investors changed
Run on Reserve Primary Fund (due to Lehman Brothers link)
Temporary extension of government insurance to MMMFs during the crisis
Ch 5-12
©McGraw-Hill Education.

Mutual Funds Continued
Money market mutual funds
25.7% of assets, 1999
37.9% of assets, 2002
27.9% in 2007, 40.9% in 2008
31.9% in 2009, 22.6% in 2015
As of 2015, 43 percent of US households owned mutual funds
Down from 52 percent in 2001
Ch 5-13
©McGraw-Hill Education.

Ch 5-14
Interest Rate Spread and Net New Cash Flow to MMMFs
©McGraw-Hill Education.

14
14

Overview of Mutual Funds
Objectives (and adherence to stated objectives), rates of return, and risk characteristics vary
Examples:
Capital appreciation funds
World equity
Investment grade bond
High-yield bond
World bond
Government bond
Ch 5-15
©McGraw-Hill Education.

Returns to Mutual Funds
Income and dividends of underlying portfolio
Capital gains on trades by mutual fund management
Capital appreciation in values of assets held in the portfolio
Marked-to-market
Net asset value (NAV)
Ch 5-16
©McGraw-Hill Education.

Web Resources
For information on the performance of mutual funds, visit:
Morningstar www.morningstar.com
Ch 5-17
©McGraw-Hill Education.

Types of Funds
Open-end fund
Comparable to most corporate securities traded on stock exchanges
Closed-end investment companies
Fixed number of shares outstanding
Example: REITs
May trade at premium or discount
Exchange traded funds (ETFs)
Load versus no-load funds
Ch 5-18
©McGraw-Hill Education.

Types of Funds Continued
Ch 5-19
Exchange traded funds (ETFs)
Fixed number of shares outstanding
May be bought/sold through broker or in brokerage account
Registered with SEC as investment companies
Retail investor cannot purchase/redeem shares directly from the ETF
©McGraw-Hill Education.

Ch 5-20
Load versus No-Load: Share of Assets
©McGraw-Hill Education.

20
20

Mutual Fund Costs
Load versus no-load funds:
Sales loads
Generally, negative effect on performance outweighs benefits
Short term versus long term investment horizon alters impact of loads on cost
Fund operating expenses
Management fee
12b-1 fees
Front end and back end fees
Class A, Class B, and Class C differences
Creation of new rules by SEC
Sweeping decreases in fees, 2005 and 2006
Ch 5-21
©McGraw-Hill Education.

Balance Sheet and Trends
Money Market Funds (MMFs)
Key assets are short-term securities (consistent with deposit-like nature)
2015: $1,804.2 billion (86.8% of total assets)
2008: flight to safety, out of corporate and foreign bonds
Most consumer-oriented shares have values fixed at $1 and adjust number of shares owned by the investor
Significant liquidity risk highlighted during crisis
Ch 5-22
©McGraw-Hill Education.

Balance Sheet and Trends Continued
Long-term funds
Stocks comprised over 70.0 % of long-term mutual fund asset portfolios in 2007 versus 55.5% in 2008
Credit market instruments next most popular assets
Shift to other securities, such as credit market instruments, when equity markets are not performing as well
Ch 5-23
©McGraw-Hill Education.

Regulation of Mutual Funds
Heavily regulated due to management and investment of small investors’ savings
Primary regulator: SEC
Emphasis on full disclosure and anti-fraud measures to protect small investors
NASD supervises mutual fund share distributions
Ch 5-24
©McGraw-Hill Education.

Regulatory Changes
Prosecutions in light of trading abuses in early 2000s
Market timing
Late trading
Directed brokerage
Improper fee assessments
Changes include SEC requirements for independent board members, reporting and disclosure requirements
Ch 5-25
©McGraw-Hill Education.

Further Regulatory Changes
Increase in requirements for disclosure
Enhanced transparency
Requirement for firms to have a chief compliance officer, 2004
Hard closing deadline of 4 PM eastern, intended to mitigate late trading abuses
Ch 5-26
©McGraw-Hill Education.

Compliance Officer
Reports directly to mutual fund directors, not executives of the fund
Responsible for reporting any wrongdoings
Policing personal trading of fund managers
Ensuring accuracy or reporting to regulators/investors
Reviewing fund business practices
Ch 5-27
©McGraw-Hill Education.

Legislation
Securities Act, 1933
Securities Exchange Act,1934
Investment Advisers Act, 1940
Investment Company Act, 1940
Insider Trading and Securities Fraud Enforcement Act,1988
Market Reform Act,1990
Allows SEC to halt trading by use of circuit breakers
Ch 5-28
©McGraw-Hill Education.

Legislation Continued
National Securities Markets Improvement Act,1996
Exempts mutual fund sellers from state securities regulatory oversight
Sarbanes-Oxley Act of 2002
Ch 5-29
©McGraw-Hill Education.

Global Issues
Worldwide growth in mutual fund investment curtailed by financial crisis
$4.545 trillion in 1999 to $14.130 trillion in 2007
Over 211% growth
Decrease to $9.316 trillion in 2008
Ch 5-30
©McGraw-Hill Education.

Global Issues
Greatest development in countries with most advanced securities markets
Japan, France, Germany, Australia, and UK
Efforts to reduce barriers for U.S. mutual fund sponsors
Europe, China and other Asian countries
Ch 5-31
©McGraw-Hill Education.

Hedge Funds
Not technically mutual funds
Exempt from a variety of regulatory constraints imposed on mutual funds for the protection of individuals
Prior to 2010, not subject to SEC regulation
Bernard L. Madoff Investment Securities, Bear Stearns High Grade Structured Credit Strategies Fund
Concern over systemic threats
High returns in 1990s
Ch 5-32
©McGraw-Hill Education.

Hedge Funds
Near collapse of Long-Term Capital Management (LTCM)
$3.6 billion bailout
Precipitated SEC scrutiny of hedge funds

Ch 5-33
©McGraw-Hill Education.

Types of Hedge Funds
More risky
Market directional
Moderate risk
Market neutral or value orientation
Risk avoidance
Market neutral; moderate, consistent returns with low risk as objectives
Associated fees
Management fees
Performance fees
Ch 5-34
©McGraw-Hill Education.

Offshore Hedge Funds
Major centers include Cayman Islands, Bermuda, Dublin, and Luxembourg
Rules:
Generally not burdensome
Anonymity
Tax advantages
Ch 5-35
©McGraw-Hill Education.

Regulation of Hedge Funds
Prior to 2010: Generally unregulated
Exemption for less than 100 investors
Exemption if accredited
Scandals:
Illegal trading with mutual funds
2007: UBS Securities, Morgan Stanley
2008: Bernard Madoff’s “Ponzi” scheme
2009: Galleon Group LLC
Resulted in heightened scrutiny
Ch 5-36
©McGraw-Hill Education.

Regulation of Hedge Funds Continued
2010 Wall Street Reform and Consumer Protection Act:
Register with SEC if assets > $100 million
States will oversee if assets < $100 million Reports to SEC Federal Reserve oversight if fund is too risky (or too large) Ch 5-37 ©McGraw-Hill Education. 37 Pertinent Websites American Funds Federal Reserve Fidelity Investments Investment Co. Institute Morningstar, Inc. NASD SEC Vanguard Wall Street Journal Ch 5-38 www.americanfunds.com www.federalreserve.gov www.fidelity.com www.ici.org www.morningstar.com www.nasd.com www.sec.gov www.vanguard.com www.wsj.com ©McGraw-Hill Education. 38

Asset and Liability Management

Fin6102

Ferriter – Spring 2018

Overview
This chapter discusses insurance companies
Two major groups:
Life
Property-casualty
Financial crisis and insurance companies
Size, structure, and composition
Balance sheets and recent trends
Regulation of insurance companies
Global competition and trends
Ch 6-2
©McGraw-Hill Education.

Insurance and Financial Crisis
Insurance companies as investors in securities
Subprime mortgage pools fell in value
Credit default swaps (CDS) fell
AIG was a major writer of CDS securities
Potential impact on other FIs that bought CDS from AIG used to justify the bailout
Increased risk exposure to banks, investment banks, and insurers
Ch 6-3
©McGraw-Hill Education.

Insurance Companies
Differences in services provided by:
Life insurance companies
Property and casualty insurance companies
Ch 6-4
©McGraw-Hill Education.

Size, Structure, and Composition
Size, structure, and composition of the insurance industry:
In 1988: 2,300 life insurance companies with aggregate assets of $1.1 trillion
In 2010s: 830 life insurance companies with aggregate assets of $6.5 trillion in 2015
Ch 6-5
©McGraw-Hill Education.

Size, Structure, and Composition Continued
4 largest life insurers wrote 33% of new business in 2014
Most policies sold through commercial banks
18% of all fixed annuities were sold by commercial banks in 2015
Ch 6-6
©McGraw-Hill Education.

Life Insurance Companies
Significant merger activity in life insurance industry
Not to same extent witnessed in banking
E.g., Anthem and Signa, MetLife and American Life Insurance, etc.
Competition from within industry and from other FIs
Increased conversion from mutual to stockholder controlled companies
Ch 6-7
©McGraw-Hill Education.

Mutual vs. Stock Insurance Companies
Ch 6-8
©McGraw-Hill Education.

Biggest Life Insurers
©McGraw-Hill Education.

9
9

Insurance Issues
Adverse selection
Insured have higher risk than general population
E.g., Matt has never had life insurance, but decides to buy some once he finds out he has a terminal illness
Alleviated by grouping of policyholders into similar risk pools
Problem for both life insurers and property-casualty insurers
Ch 6-10
©McGraw-Hill Education.

Types of Life Insurance
Life insurance products:
Ordinary life
Term life, whole life, endowment life
Variable life, universal life and variable universal life
Group life
Industrial life
Credit life
Ch 6-11
©McGraw-Hill Education.

Ch 6-12
Distribution of Premiums, 2015
©McGraw-Hill Education.

12
12

Other Life Insurer Activities
Annuities
Reverse of life insurance activities
Topped $325.2 billion in 2014
Private pension plans
Insurers compete with other financial service companies
In 2015, life insurers managed over $2.7 trillion (~40% of all private pension plans)
Accident and health insurance
Protects against morbidity (i.e., ill health) risk
Over 168.7 billion in premiums in 2014
Ch 6-13
©McGraw-Hill Education.

Balance Sheet
Assets
Need to generate competitive returns on savings components of life insurance policies
Focus investment on long-term assets
Bonds, equities, government securities
Policy loans
Liabilities
Policy reserves to meet policyholders’ claims
Separate account business represented 38.2% of total liabilities and capital in 2015
Ch 6-14
©McGraw-Hill Education.

Recent Trends
Impact of financial crisis
Drop in value of securities
Capital losses from bonds and stocks exceeded $35 billion
Historically low short-term interest rates
Adverse impact on ability to lower rates on new policies
Incentive to surrender existing policies
Dwindling reserves led to Treasury Department extending bailout funds
Late 2009 showed improvement
Ch 6-15
©McGraw-Hill Education.

Regulation
McCarran-Ferguson Act of 1945
Confirms primacy of state over federal regulation
State insurance commissions
Coordinated examination system developed by NAIC
Federal Reserve
Supervises ~1/3 of U.S. insurance industry assets
States promote life insurance guarantee funds
Ch 6-16
©McGraw-Hill Education.

Recent Regulatory Issues
Fear of systemic risk posed by AIG
2009: Proposals to create optional federal life insurance charter
Proponents of federal charter argued inconsistent regulation and barriers to innovation inherent in current system
2010: Wall Street Reform and Consumer Protection Act established the Federal Insurance Office (FIO)
Ch 6-17
©McGraw-Hill Education.

Web Resources
For more detailed information on insurance regulation, visit:

NAIC www.naic.org

Ch 6-18
©McGraw-Hill Education.

Property-Casualty Insurance
Size and Structure
Currently about 2,640 companies sell property-casualty insurance
Highly concentrated
Top 10 firms have 50% of market in terms of premiums written
Top 200 firms write over 95% of total premiums
M&A activity is increasing concentration
Ch 6-19
©McGraw-Hill Education.

Types of P&C Products
Fire insurance
Homeowners multiple-peril insurance
Commercial multiple-peril insurance
Automobile liability and physical damage insurance
Liability insurance (other than automobile)
Ch 6-20
©McGraw-Hill Education.

Premium Allocation
Changing composition of net premiums written, 2014 versus 1960:
Fire: 2.3% vs. 16.6% in 1960
Homeowners MP: 15.2% vs. 5.2% in 1960
Commercial MP: 6.9% vs. 0.4% in 1960
Auto L&PD: 38.6% vs. 43% in 1960
Other liability: 12.7% vs. 6.6% in 1960
Ch 6-21
©McGraw-Hill Education.

P&C Balance Sheet
Similar to life insurance companies; long-term securities
Unlike life insurance companies; requirement for liquid assets
Major liabilities:
Loss reserves
Loss adjustment expenses
Unearned premiums
Ch 6-22
©McGraw-Hill Education.

Loss Risk
Underwriting risk may result from:
Unexpected increases in loss rates
Unexpected increases in expenses
Unexpected decreases in investment yields or returns
Property versus liability
Losses from liability insurance less predictable
Example: Claims due to asbestos damage to workers’ health
Ch 6-23
©McGraw-Hill Education.

Loss Risk Continued
Severity versus frequency
Loss rates more predictable on low-severity, high-frequency lines (such as fire, auto, and homeowners) than on high-severity, low-frequency lines (such as earthquake, hurricane, and financial guaranty)
Higher uncertainty forces PC insurers to invest in more short-term assets and hold larger capital and reserves than life insurers
Ch 6-24
©McGraw-Hill Education.

Insurance Risks Post 9/11
Crisis generated by terrorist attacks forced creation of federal terrorism insurance program in 2002
Federal government provides backstop coverage under Terrorism Risk Insurance Act of 2002 (TRIA)
Caps losses for insurance companies
Ch 6-25
©McGraw-Hill Education.

Long Tail Versus Short Tail
Long-tail risk exposure
Arises where loss occurs during coverage period but claim is not made until many years later
Examples: Asbestos cases and Dalkon shield case
Efforts to contain long-tail risks within subsidiaries
Example: Halliburton
Ch 6-26
©McGraw-Hill Education.

Insurance Costs: Social Inflation
Product inflation versus social inflation
Unexpected inflation may be systematic or line-specific
Social inflation: Unexpected changes in awards by juries
Reinsurance
Approximately 75 percent of reinsurance by US firms is written by non-US firms, such as Munich Re
Ch 6-27
©McGraw-Hill Education.

Underwriting Profitability
Loss ratios have generally increased
Expense ratios have generally decreased
Attributed to change in distribution methods
Insurers have begun selling directly to consumers through their own brokers rather than independent brokers
Combined ratio:
Includes both loss and expense experience
If greater than 100, premiums are insufficient to cover losses and expenses
Ch 6-28
©McGraw-Hill Education.

Investment Yield / Return Risk
Operating ratio = combined ratio after dividends minus investment yield
Importance of investment income:
Causes PC managers to place importance on measuring and managing credit and interest rate risk
Ch 6-29
©McGraw-Hill Education.

P&C: Recent Trends
Several catastrophes over 1985 – 2015
Hurricane Hugo 1989, San Francisco Earthquake 1991, Oakland fires 1991, Hurricane Andrew 1991
2004 hurricanes (Charley, Frances, Ivan, Jeanne) occurred in rapid succession and generated claims comparable to Andrew
Hurricane Katrina, 2005
September 11, 2001 terrorist attacks created an insurance crisis (and heightened demand)
Hurricane Sandy, 2011
Potential for crowding out market solutions (catastrophe bonds) via government actions
Ch 6-30
©McGraw-Hill Education.

PC Regulation
PC insurers chartered and regulated by state commissions
State guaranty funds
National Association of Insurance Commissioners (NAIC) provides various services to state commissions
Includes Insurance Regulatory Information System (IRIS)
Many lines face rate regulation
Criticism over Katrina-related claims
Ch 6-31
©McGraw-Hill Education.

Global Issues
Insurance industry becoming increasingly global
Worldwide, 2011 was a bad year for both life and PC insurers
Japan’s earthquake and tsunami
Earthquakes in New Zealand
Floods in Thailand
Severe tornadoes in US
Ch 6-32
©McGraw-Hill Education.

Pertinent Websites
A.M. Best
Federal Reserve
Insurance Information Institute
Insurance Services Offices
National Association of Insurance Commissioners
Ch 6-33
www.ambest.com

www.federalreserve.gov

www.iii.org

www.iso.com

www.naic.org

©McGraw-Hill Education.

Asset and Liability Management

FIN 6102

Ferriter – Spring 2018

Debt Securities
A Debt Security is a claim on a specified periodic stream of cashflow. Debt Securities are often called fixed-income securities because they promise either a fixed stream of income or one that is determined by a formula.
A typical bond requires semi-annual payments for the life of the bond. These are called coupon payments. The interest rate that determines the coupon payment is called the coupon rate.
When a bond matures, the issuers repays the debt by paying the bond’s par value (also known as the face value).
If no face value is given, assume $1000 for the face value

Zero-Coupon Bonds
Bonds are usually issued with a high enough coupon rate to induce investors to purchase the bond. However there are zero-coupon bonds, where the buyer only receives the face value at the maturity date but receive no coupons payments.
When these bonds are issued they are priced considerably lower than the par value. They may be issued by federal, state or local governments or by corporations. Then there are the tax exemptions. If issued by a government entity, the interest generated by a zero-coupon bond is often exempt from federal income tax, and often from state and local income taxes too.

Accrued Interest and Quoted Prices
The bond prices quoted in financial papers are not the actual prices that an investors pays for the bond. This is because the quoted price doesn’t include the interest that accrues between coupon payments.
Accrued Interest = Annual Coupon Payment/2 *Days since last coupon/Days between payment
For example, a bond with a coupon rate of 8%. The annual coupon payment is $80 and the semi-annual coupon is $40. 30 days have passed since the last coupon payment. What is the the accrued interest?
$40 x (30/182) = $6.59
This value would be added to the quoted price when the bond is sold.

Call Provision and Callable Bonds
Some corporate bonds are issued with a call provision. A call provision allows the issuers to repurchase a bond at a specified call price before the maturity date. Why might a company issue a callable bond?
When corporate bonds are issued in a high interest rate environment, they will most likely issue bonds with a high coupon rate. Over the course of the bonds life, interest rates might fall. A corporation might take advantage of the call provision to retire the bond early and issue a new bond at a lower coupon rate
Callable Bonds typically come with a period of call protection, an initial period of time when the bond cannot be called.
The option to call a bond is useful to the issuer, but what is beneficial to an issuer is detrimental to bond holders. To compensate for this, callable bonds are often issued with higher coupons and promised yield to maturity than non callable bonds.

Convertible bonds
Convertible bonds give bondholders an option to exchange each bond for a specified number of shares. The conversion ratio is the number of shares for which each bond may be exchanged. For example, a convertible bond is issued at a par value of $1,000 and is convertible in 40 shares of stock. If the current stock price is $20 it is not profitable to convert. As $20*40 = $800 is less than the par value of the bond. If the stock price increases to $30, the conversion is profitable ($30*40 = $1,200)
The market conversion value is the current value of shares for which the bonds may be exchanged.
Convertible bond holders benefit from price appreciation of the company’s stock. Because of this benefit, convertible bonds tend to have lower coupon rates and lower yields to maturity.

Floating Rate Bonds
Floating rate bonds make interest payments based on some measure of current market rates. For example, the might might be adjusted annually to the current T-bill rate plus 2%. If the One year T-Bill rate is 4%, then the coupon rate over the next year will be 6%.
The major risk with floating-rate bonds is that while the spread between the market interest rate and the floating coupon rate is fixed, the adjustment is not connected to changes in the issuing firm’s financial position. For example, if a company runs into financial distress, investors might demand a greater yield premium than is offered by the security. In this case the price of the bond will fall.

Bond Pricing
Bond Value = Present Value of Coupons + Present Value of par value
For example consider an 8% coupon, 30-year maturity bond with a par value of $1,000, paying 60 semiannual coupon payments of $40 each. Suppose that the market interest rate is 8% annually.
The present value of all the coupon payments is $904.94 and the present value of the par value is $95.06. When the market interest rate is equal to the coupon rate, the par value and equals the bond price.
If the market interest rate were to rise to 10%. The bond price would fall by $189.29 to $810.71

Yield to Maturity
As you may have guessed, the coupon rate and the market interest rate are rarely equal. As such bonds usually do not sell for par value. Therefore we need to measure or rate of return that accounts for both current income (coupon payments and the return of principle) and the bond price increase or decrease over the lifetime of the bond.
The yield to maturity is the interest rate that makes the present value of a bond’s payments equal to its current price. This interest rate is interpreted as the average rate of return of a bond if held to maturity.
Example: An 8% coupon, 30-year bond is selling at $1,276.76. What is the yield to maturity?
In this example, the semiannual yield to maturity is .03. However, yield to maturity is generally quoted as an annual figure. Therefore we must annualize the yield. 1.03^2 =1.0609.
In this case the yield to maturity in 6.09%

YTM vs Current Yield
A bond’s yield to maturity (YTM) is the internal rate of return on the investment in the bond. YTM differs from the current yield of a bond. The current yield of a bond is defined as the annual coupon payment divided by the current price of a bond.
For example, take the 8% coupon bond selling for $1,276.76. The current yield would be 80/ $1,276.76 or .0627 (6.27%). Recall that the YTM on this bond was 6.09%. This bond is considered to be selling at a premium. In this case the coupon rate is higher than the current yield which is higher than the YTM.
The reason for this is that the Coupon rate is divided par value, the current yield is divided by the current price. The current yield is higher than the YTM because the YTM accounts for the capital loss as the bond will eventual repay only $1,000 at maturity.
As a general rule, for premium bonds the Coupon rate > Current Yield > YTM. For discount bonds the relationship is reversed.

Yield to Call
Yield to maturity assumes that the bond will be held to maturity. However, a bond maybe be retired prior to that time. This is especially true if the bond has a call provision. For example, a $1,000, 30 year bond with a coupon payment of 8% has a callable provision at 110% of par value and has call protection for 10 years. If the bond currently sells for $1,150 what is the yield to call?

In this example, the Yield to Call (YTC) is equal to 6.64% (3.32 x 2) and the YTM is 6.82%

Yield to Call Yield to Maturity
Coupon Payment 40 40
Number of Periods 20 60
Final Payment $1,100 $1,000
Price $1,150 $1,150

Zero-Coupon Bonds
US Treasury Bill are common for of short term zero-coupon bonds. Since these have no coupon the return on these bonds is completely from price appreciation. However, Long-Term Zero coupon bonds are usually created by separating a coupon payment stream from the principal repayment. An investor can request that the US Treasury split or strip the coupon payment from the principal repayment. In this case each component is assigned a CUSIP number, the CUSIP allows the each security to trade on the FEDWIRE system.
The process is governed by the US Treasury Program called STRIPS (Separate Trading of Registered Interest and Principal of Securities)
The primary purpose of strips is to appeal to different investor types. Much of the reason is related to cashflow matching.

Term Structure of Interest Rate
The term structure of interest rates refers to the the process of discounting cash flows of different maturities.
Most often investors will plot the YTM against Maturity. This is called the yield curve. There are three common “types” of yield curve; rising, flat and inverted. A rising yield curve is the most common in normal economic times, and it suggests that interest rates will rise in the future. The yield curve is derived from plotting zero-coupon bonds.
Maturity YTM Price
1 5% $952.38
2 6% $890
3 7% $816.30
4 8% $735.03

Yield Curve and Future Interest Rates
In order to derive the Yield curve we’ll be making some assumptions. First, we assume that there is no possibility of arbitrage. Under this scenario, yields from must be identical.
To see what this means, consider the following. There are two strategies, a choice to buy and hold a two year zero-coupon bond and to buy a one year zero coupon bond and reinvest in another one year zero coupon.
For the two year bond, assume a 6% market rate for a holding period of years. In this case the bond price would be $890. For the second strategy, assume the interest rate for a one year holding period is 5%. What will the one year rate be in one year
We can set this up as the following:
$890 x 1.062 = $890 x 1.05 x (1+r)
Or 1.062/1.05 = 1+r = 1.0701 or 7.01%

Finding Future Short Rates
Now let’s compare a three year strategy. One will be to purchase a 3 year zero coupon bond with a YTM of 7%. This bond would be priced at $816.30
The alternative strategy is to buy a 2 year zero and reinvest in a 1 year zero.
We can structure this as follows
1.073 = 1.062 x 1+r
1.073/1.062 = 1+r
This equals 1.09025 or 9.025%
Additionally, 1.07 = (1.05 x 1.0601 x 1.09025)1/3

Interest Rate Types
One thing you might have noticed is that there are a lot of interest rates when doing these calculations. In order to differentiate between them, investors coined two terms to describe them.
The spot rate refers to the yield to maturity for a zero coupon bond that prevails today.
The forward rate (also called the forward yield) is the theoretical, expected yield on a bond several months or years from now. It is common to denote a forward rate as xRy this can be read as the x forward rate y years from today.

Theories of the Term Structure
The expectations hypothesis is the theory that the forward rate equals the market consensus expectations of what future short-term rates will be. This means that there is no liquidity preference.
This can be stated as E(r) = f2 or that the expected rate in period two will be the rate in period two.
Using this hypothesis is what allows use to generate a yield curve, as no other information is required aside from current spot rates.

Theories of Term Structure
Liquidity Preference: Essentially states that investors or buyers of fixed income securities have a preference of either short term or long term securities. Part of the reason for these preferences can be seen as attempts to match cash inflows to cash outflows.
In any event, short term investors would require a premium to invest in longer term securities, or the f2 > E(r2) or the rate in period 2 must be greater than the expected rate in period 2.
Advocates of liquidity preference believe that short term investors dominate the market which pushes the short term interest rate down.

Interest Rate Risk
As we’ve seen bond prices move inversely to changes in the market interest rate. Therefore, bond investors are particularly concerned with the sensitivity of bond prices. We also note that bond prices are convex and therefore decreases in YTM have bigger impacts on price than increases in YTM for the same magnitude. A summary of bond price observations
Bond prices and yields are inversely related.
An increase in a bond’s yield to maturity results in a smaller price change than a decrease
Prices of long-term bonds tend to be more sensitive to changes in interest rate.
Sensitivity to price changes increases at a decreasing rate. A 30 year bond is not 6x more sensitive than a 5 year
Interest rate risk is inversely related to a bond’s coupon rate
The sensitivity of a bond’s price to a change in its yield is inversely related to the YTM at which the bond is currently selling.

(Macaulay’s) Duration
Frederick Macaulay termed the effective maturity concept the duration of a bond. Macaulay’s Duration equals the weighted average of the times to each coupon or principal payment. The weight associated with each payment time should be related to the “importance” of that payment to the value of the bond. Timing of cash flows is designated in years
Wt = PV of CFt/Bond Price
D = Σ T x Wt

Duration Example
Time until PV of CF Column C
Payment Discount rate = times
Period (Years) Cashflow 5% per period Weight Column F
A. 8% Coupon Bond 1 0.5 40 $ 38.10 0.039496 0.0197
2 1 40 $ 36.28 0.037615 0.0376
3 1.5 40 $ 34.55 0.035824 0.0537
4 2 1040 $ 855.61 0.887065 1.7741
Sum: $ 964.54 1.8852

B Zero-Coupon 1 0.5 0 $ – 0 0.0000
2 1 0 $ – 0 0.0000
3 1.5 0 $ – 0 0.0000
4 2 1000 $ 822.70 1 2.0000
$ 822.70 2.0000

Why is duration important
There are three primary reasons why duration is important.
First it is a simple summary statistic of the effective average maturity of the portfolio
It is an essential tool in immunizing portfolios from interest rate risk
Duration measures interest rate sensitivity of a portfolio

Modified Duration

Reason for – sign The price-yield relationship is negatively correlated; when prices go down, the implied yield goes up. The minus sign allows the modified duration to be positive for a normal bond.
23

Modified Duration Example
Consider the 2-year maturity, 8% coupon bond, selling at a price of $964.54 for a YTM of 10%. The semi-annual duration of this bond is 1.8852 years. The annual duration is 3.7704. Therefore modified duration is 3.7704/1.05 = 3.591.
No suppose that the semiannual interest rate increases to 5.01%
-3.591x .01% = -.03591%
This would be interpreted as a .01% increase in interest rates would cause the price of a bond to fall by .03591%

Rules for Duration
The duration of a zero-coupon bond is its time to maturity
A coupon bond can have a duration less than one.
Holding maturity constant, a bond’s duration is lower when the coupon rate is higher
A bond’s duration increases with its time to maturity.
The duration for a coupon bond is higher when the bond’s yield to maturity is lower
Duration of a perpetuity (1+r)/r

Convexity

Convexity Formula

Duration with Convexity Example

Immunization
Immunization techniques refer to strategies used by investors to shield their overall financial status from interest rate risk.
Many banks and thrifts have naturally occurring mismatches between their liabilities and assets. Much of there liabilities are deposits that are short term and have low duration. Bank assets are primarily consumer and commercials loads and have higher duration. This means that banks are sensitive to changes in interest rate as they can directly effect new worth.

Immunization Example
Consider an insurance company offering a Guaranteed Investment Contract for $10,000 and guarantees and interest rate of 8%. If the GIC has a maturity of 5 years. The future value of the liability is $14,693.28.
If the company chooses to fund the liability with a 10,000 8% coupon bond. Then as long as interest rates remain at 8% the liability will be exactly matched.
But what happens when interest rate rise or fall?

Immunization Example
Payment Number Years Remaining until Obligation Accumulated Value of Invested Payment
A. Rates Remain at 8%
1 4 800 x (1.08)^4 = 1088.391
2 3 801 x (1.08)^3 = 1007.77
3 2 802 x (1.08)^2 = 933.12
4 1 803 x (1.08)^1 = 864
5 0 804 x (1.08)^0 = 800
Sale of Bond 0 10800 = 10000
14693.28

A. Rates Fall to 7%
1 4 800 x (1.07)^4 = 1048.637
2 3 801 x (1.07)^3 = 980.0344
3 2 802 x (1.07)^2 = 915.92
4 1 803 x (1.07)^1 = 856
5 0 804 x (1.07)^0 = 800
Sale of Bond 0 10800 = 10093.46
14694.05

A. Rates Fall to 7%
1 4 800 x (1.09)^4 = 1129.265
2 3 801 x (1.09)^3 = 1036.023
3 2 802 x (1.09)^2 = 950.48
4 1 803 x (1.09)^1 = 872
5 0 804 x (1.09)^0 = 800
Sale of Bond 0 10800 = 9908.257
14696.03

Immunization
In this example because we have successfully matched the duration of our asset with our liability we can be considered immune from interest rate risk. However, immunization investors have a risk trade off between price risk and reinvestment risk.
Price risk is essentially the capital loss or gain that occurs because of a change in interest rate. Now a key consideration with immunization is the need to rebalance. As interest rate change a portfolio manager must rebalance as the duration will have changed.
Additionally, even if interest rates stay the same durations will change solely because of the passage of time.

Constructing and Immunized Portfolio
A bank must make a payout of $19,487 in seven years. The current market interest rate is 10%, so the PV of the payout is $10,000. The portfolio managers wants to fund the obligation with a 3 year zero coupon bond and a perpetuity paying 10%. How can the manager immunize the portfolio?
Calculate the duration of the liability. In this case because it is a single payment obligation, the duration is 7 years
Calculate the duration of the asset portfolio. The portfolio duration will be the weighted average of each assets duration. In this case the zero coupon bond has a duration of 3 years and the perpetuity a duration of 11 years.
Asset Duration = w * 3 + (1-w)*11
Find the asset mix that sets the duration of assets equal to 7 years
w * 3 + (1-w)*11 = 7 in this case w = .5
Fully fund the obligation. In this case it means that 5,000 should be invested in the zero coupon bond and 5,000 should be invested in the perpetuity.

Duration Gap Analysis
Duration Gap:
From the balance sheet, A = L+E, which means E = A-L. Therefore, DE = DA-DL.
In the same manner used to determine the change in bond prices, we can find the change in value of equity using duration.
DE = -[DA – DLk]A(DR/(1+R))
DLk is total liabilities / (Total Liabilies + Equity) or the proportion of assets funded by liabilities
Suppose a manager has the following situation:
Duration of Assets = 5 years and Duration of Liabilities = 3 years
The current interest rate is 10% and it is expected to rise to 11% what is the impact on the net worth of the company

Duration Gap Analysis
Assets Liabilities and Equity
Assets 100 Liabilities 90
Equity 10

First let’s calculate the potential impact on net worth.
DE = -[DA – DLk] x A x (DR/(1+R))
-[5-3*.9] x 100 x (.01/1.10)
or -2.09 decrease in equity
What about Asset and Liability Accounts?
DA = -5(.01/1.10) = -.04545 = -4.545% = 95.45
DL = -3(.01/1.10) = -.02727 = -2.727% = 87.54

New Balance Sheet
Assets Liabilities and Equity
Assets 95.45 Liabilities 87.54
Equity 7.91

Duration Gap Example

Duration and Repricing Gap Example

Asset and Liability Management for Financial Ins

Ferriter

FIN 6102 – Spring 2018

Interest Rates and Net Worth
FIs exposed to interest rate risk due to maturity mismatches between assets and liabilities
Interest rate changes can have severe impact on net worth
Thrifts, during 1980s
Ch 8-2
©McGraw-Hill Education.

US Treasury Bill Rate, 1965 – 2015
©McGraw-Hill Education.
Ch 8-3

3
3

Level and Movement of Interest Rates
Federal Reserve: U.S. central bank
Open market operations influence money supply, inflation, and interest rates
Actions of Fed (December, 2008) in response to economic crisis
Target rate between 0.0 and ¼ percent
Ch 8-4
©McGraw-Hill Education.

Central Bank and Interest Rates
Actions mostly target short term rates
Focus on federal funds rate, in particular
Interest rate changes and volatility increasingly transmitted from country to country due to increased globalization of financial markets
Statements by Jerome Powell can have dramatic effects on world interest rates
Ch 8-5
©McGraw-Hill Education.

Repricing Model
Repricing, or funding gap, model based on book value
Contrasts with market value-based maturity and duration models in appendix
Ch 8-6
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Repricing Model Continued
Rate sensitivity means repricing at (or near) current market interest rates within a specified time horizon
Repricing gap is the difference between rate-sensitive assets (RSAs) and rate-sensitive liabilities (RSLs)
Refinancing risk
Reinvestment risk
Ch 8-7
©McGraw-Hill Education.

Maturity Buckets
Commercial banks must report quarterly repricing gaps for assets and liabilities with maturities of:
One day
More than one day to three months
More than three months to six months
More than six months to twelve months
More than one year to five years
More than five years
Ch 8-8
©McGraw-Hill Education.

Repricing Gap Example
Cum.
Assets Liabilities Gap Gap
1-day $ 20 $ 30 $-10 $-10
>1day-3mos. 30 40 -10 -20
>3mos.-6mos. 70 85 -15 -35
>6mos.-12mos. 90 70 +20 -15
>1yr.-5yrs. 40 30 +10 -5
>5 years 10 5 +5 0
Ch 8-9
©McGraw-Hill Education.

Applying the Repricing Model
NIIi = (GAPi) Ri = (RSAi – RSLi) Ri
Example 1:
In the one day bucket, gap is -$10 million. If rates rise by 1%,
NIIi = (-$10 million) × .01 = -$100,000
Ch 8-10
©McGraw-Hill Education.

Applying the Repricing Model Continued
Example 2:
If we consider the cumulative 1-year gap,
NIIi = (CGAP) Ri = (-$15 million)(.01)
= -$150,000
Ch 8-11
©McGraw-Hill Education.

Rate-Sensitive Assets
Examples from hypothetical balance sheet:
Short-term consumer loans: Repriced at year-end, would just make one-year cutoff
Three-month T-bills: Repriced on maturity every 3 months
Six-month T-notes: Repriced on maturity every 6 months
30-year floating-rate mortgages: Repriced (rate reset) every 9 months
Ch 8-12
©McGraw-Hill Education.

Rate-Sensitive Liabilities
RSLs bucketed in same manner as RSAs
Demand deposits warrant special attention
Generally considered rate-insensitive (act as core deposits), but there are arguments for their inclusion as rate-sensitive liabilities
Ch 8-13
©McGraw-Hill Education.

GAP Ratio
May be useful to express interest rate sensitivity in ratio form as CGAP/Assets, referred to as “gap ratio”
Provides direction and scale of exposure
Example:
Gap ratio = CGAP/A = $15 million / $270 million = 0.056, or 5.6 percent
Ch 8-14
©McGraw-Hill Education.

Equal Rate Changes on RSAs, RSLs
Example 8-1: Suppose rates rise 1% for RSAs and RSLs. Expected annual change in NII,
NII = CGAP ×  R
= $15 million × .01
= $150,000
CGAP is positive, change in NII is positively related to change in interest rates
CGAP is negative, change in NII is negatively related to change in interest rates
Ch 8-15
©McGraw-Hill Education.

Unequal Changes in Rates
If changes in rates on RSAs and RSLs are not equal, the spread changes
In this case,
NII = (RSA × RRSA ) – (RSL × RRSL )
Ch 8-16
©McGraw-Hill Education.

Unequal Rate Change Example
Example 8-2:
RSA rate rises by 1.2% and RSL rate rises by 1.0%
NII =  interest revenue –  interest expense
= ($155 million × 1.2%) – ($155 million × 1.0%)
= $310,000
Ch 8-17
©McGraw-Hill Education.

Weaknesses of Repricing Model
Weaknesses:
Ignores market value effects of interest rate changes
Overaggregative
Distribution of assets and liabilities within individual buckets is not considered
Mismatches within buckets can be substantial
Ignores effects of rate-insensitive runoffs
Bank continuously originates and retires consumer and mortgage loans
Runoff of rate-insensitive asset/liability is rate-sensitive
Ch 8-18
©McGraw-Hill Education.

Weaknesses of Repricing Model Continued
Off-balance-sheet items are not included when considering cash flows
Hedging effects of off-balance-sheet items not captured
Example: Futures contracts
Ch 8-19
©McGraw-Hill Education.

The Maturity Model
Explicitly incorporates market value effects
For fixed-income assets and liabilities:
Rise (fall) in interest rates leads to fall (rise) in market value
The longer the maturity, the larger the fall (rise) in market value for interest rate increase (decrease)
Fall in value of longer-term securities increases at diminishing rate for given increase in interest rates
Ch 8-20
©McGraw-Hill Education.

Maturity of Portfolio
Maturity of portfolio of assets (liabilities) equals weighted average of maturities of assets (liabilities) that make up the portfolio
Principles stated on previous slide regarding individual securities apply to portfolios, as well
Typically, maturity gap, MA – ML, > 0 for most banks and thrifts
Ch 8-21
©McGraw-Hill Education.

Effects of Interest Rate Changes
Size of the gap determines the size of interest rate change that would drive net worth to zero
Immunization
Maturity matching, MA – ML = 0
Note: Doesn’t always protect FI against interest rate risk
Ch 8-22
©McGraw-Hill Education.

Leverage
Leverage affects ability to eliminate interest rate risk using maturity model
Example: $100 million in assets invested in one-year, 10% coupon bonds and $90million in liabilities in one-year deposits paying 10%.
Maturity gap is zero, but exposure to interest rate risk is not zero.
Ch 8-23
©McGraw-Hill Education.

Duration
Matching of maturities can still result in interest rate risk due to the timing of cash flows between assets and liabilities not being perfectly matched
FI can only immunize against interest rate risk by matching average lives of an assets and liabilities
See Chap. 9
Ch 8-24
©McGraw-Hill Education.

Term Structure of Interest Rates
Compares market yields or interest rates on securities
Assumes all characteristics (i.e., default risk, coupon rate, etc.) are the same, except for maturity
Most common shapes of yield curve for Treasury securities
Upward-sloping
Downward-sloping, or inverted
Flat

Ch 8-25
©McGraw-Hill Education.

Unbiased Expectations Theory
At a given point in time, yield curve reflects market’s current expectations of future short-term rates
Long-term rates are geometric average of current and expected short-term interest rates
(1 +1RN)N = (1+ 1R1)[1+E(2r1)]…[1+E(Nr1)]
Ch 8-26
©McGraw-Hill Education.

Liquidity Premium Theory
Weaknesses of unbiased expectations theory
Assumes investors are risk-neutral
Doesn’t recognize that forward rates aren’t perfect predictors of future interest rates
Liquidity premium theory
Allows for future uncertainty
Implicitly assumes that investors prefer short-term securities

Ch 8-27
©McGraw-Hill Education.

Market Segmentation Theory
Investors have specific preferences in terms of maturity
Securities with different maturities are not perfect substitutes
Investors are risk averse to securities that do not meet their maturity preferences
Yield curve reflects intersection of demand and supply of individual maturities
Ch 8-28
©McGraw-Hill Education.

Market Segmentation and Determination of Slope of Yield Curve

©McGraw-Hill Education.
Ch 8-29

Maturity Model Weaknesses
Two major shortcomings
Does not account for the degree of leverage in the FI’s balance sheet
Ignores the timing of the cash flows from the FI’s assets and liabilities
Ch 8-30
Ch 8-30
©McGraw-Hill Education.

Overview
This chapter discusses a market value-based model for managing interest rate risk, the duration gap model
Duration
Computation of duration
Economic interpretation
Immunization using duration
Problems in applying duration
©McGraw-Hill Education.
Ch 9-31

Price Sensitivity and Maturity
In general, the longer the term to maturity, the greater the sensitivity to interest rate changes
The longer maturity bond has the greater drop in price because the payment is discounted a greater number of times
©McGraw-Hill Education.
Ch 9-32

Duration
Duration
Weighted average time to maturity using the relative present values of the cash flows as weights
More complete measure of interest rate sensitivity than is maturity
The units of duration are years
To measure and hedge interest rate risk, FI should manage duration gap rather than maturity gap
©McGraw-Hill Education.
Ch 9-33

Macaulay’s Duration

where
D = Duration measured in years
CFt = Cash flow received at end of period t
N= Last period in which cash flow is received
DFt = Discount factor = 1/(1+R)t

©McGraw-Hill Education.
Ch 9-34

Duration
Since the price (P) of the bond equals the sum of the present values of all its cash flows, we can state the duration formula another way:

Notice the weights correspond to the relative present values of the cash flows

©McGraw-Hill Education.
Ch 9-35

Semiannual Cash Flows
For semiannual cash flows, Macaulay’s duration, D, is equal to:

©McGraw-Hill Education.
Ch 9-36

Duration of Zero-Coupon Bond
Zero-coupon bonds: sell at a discount from face value on issue, pay the face value upon maturity, and have no intervening cash flows between issue and maturity
Duration equals the bond’s maturity since there are no intervening cash flows between issue and maturity
For all other bonds, duration < maturity because here are intervening cash flows between issue and maturity ©McGraw-Hill Education. Ch 9-37 37 Duration of Consol Bonds A bond that pays a fixed coupon each year indefinitely Have yet to be issued in the U.S. Maturity of a consol (perpetuity): Mc =  Duration of a consol (perpetuity): Dc = 1 + 1/R ©McGraw-Hill Education. Ch 9-38 Features of Duration Duration and maturity Duration increases with maturity of a fixed-income asset/liability, but at a decreasing rate Duration and yield Duration decreases as yield increases Duration and coupon interest Duration decreases as coupon increases ©McGraw-Hill Education. Ch 9-39 Economic Interpretation Duration is a direct measure of interest rate sensitivity, or elasticity, of an asset or liability: [ΔP/P]  [ΔR/(1+R)] = -D Or equivalently, ΔP/P = -D[ΔR/(1+R)] = -MDdR where MD is modified duration ©McGraw-Hill Education. Ch 9-40 Economic Interpretation Continued To estimate the change in price, we can rewrite this as: ΔP = -D[ΔR/(1+R)]P = -(MD) × (ΔR) × (P) ©McGraw-Hill Education. Ch 9-41 41 Dollar Duration Dollar value change in the price of a security to a 1 percent change in the return on the security Dollar duration = MD × Price Using dollar duration, we can compute the change in price as ΔP = -Dollar duration × ΔR ©McGraw-Hill Education. Ch 9-42 Semi-annual Coupon Bonds With semi-annual coupon payments, the percentage change in price is calculated as: ΔP/P = -D[ΔR/(1+(R/2)] ©McGraw-Hill Education. Ch 9-43 Immunization Matching the maturity of an asset with a future payout responsibility does not necessarily eliminate interest rate risk Matching the duration of a fixed-interest rate instrument (i.e., loan, mortgage, etc.) to the FI’s target or investment horizon will immunize the FI against shocks to interest rates ©McGraw-Hill Education. Ch 9-44 Balance Sheet Immunization Duration gap is a measure of the interest rate risk exposure for an FI If the durations of liabilities and assets are not matched, then there is a risk that adverse changes in the interest rate will increase the present value of the liabilities more than the present value of assets is increased ©McGraw-Hill Education. Ch 9-45 Immunizing the Balance Sheet of an FI Duration Gap: From the balance sheet, A = L+E, which means E = A-L. Therefore, DE = DA-DL. In the same manner used to determine the change in bond prices, we can find the change in value of equity using duration. DE = -[DA - DLk]A(DR/(1+R)) ©McGraw-Hill Education. Ch 9-46 Duration and Immunizing The formula, DE, shows 3 effects: Leverage adjusted duration gap The size of the FI The size of the interest rate shock ©McGraw-Hill Education. Ch 9-47 Example 9-9 Suppose DA = 5 years, DL = 3 years and rates are expected to rise from 10% to 11%. (Thus, rates change by 1%). Also, A = 100, L = 90, and E = 10. Find DE. DE = -[DA - DLk]A(DR/(1+R)) = -[5 - 3(90/100)]100[.01/1.1] = - $2.09. Methods of immunizing balance sheet. Adjust DA, DL or k. ©McGraw-Hill Education. Ch 9-48 Immunization and Regulatory Considerations Regulators set target ratios for an FI’s capital (net worth) to assets in an effort to monitor solvency and capital positions: Capital (Net worth) ratio = E/A If target is to set (E/A) = 0: DA = DL But, to set E = 0: DA = kDL ©McGraw-Hill Education. Ch 9-49 Difficulties in Applying Duration Model Duration matching can be costly Growth of purchased funds, asset securitization, and loan sales markets have lowered costs of balance sheet restructurings Immunization is a dynamic problem Trade-off exists between being perfect immunization and transaction costs Large interest rate changes and convexity ©McGraw-Hill Education. Ch 9-50 Convexity The degree of curvature of the price-yield curve around some interest rate level Convexity is desirable, but greater convexity causes larger errors in the duration-based estimate of price changes ©McGraw-Hill Education. Ch 9-51 Basics of Bond Valuation Formula to calculate present value of bond: ©McGraw-Hill Education. Ch 9-52 Impact of Maturity on Security Values Price sensitivity is the percentage change in a bond’s present value for a given change in interest rates Relationship between bond price sensitivity and maturity is not linear As time remaining to maturity on bond increases, price sensitivity increases at decreasing rate ©McGraw-Hill Education. Ch 9-53 Incorporating Convexity into the Duration Model Three characteristics of convexity: Convexity is desirable Convexity and duration All fixed-income securities are convex ©McGraw-Hill Education. Ch 9-54 Modified Duration & Convexity DP/P = -D[DR/(1+R)] + (1/2) CX (DR)2, or DP/P = -MD DR + (1/2) CX (DR)2 Where MD implies modified duration and CX is a measure of the curvature effect CX = Scaling factor × [capital loss from 1bp rise in yield + capital gain from 1bp fall in yield] Commonly used scaling factor is 108 ©McGraw-Hill Education. Ch 9-55 Calculation of CX Example: convexity of 8% coupon, 8% yield, six-year maturity Eurobond priced at $1,000 CX = 108[(DP-/P) + (DP+/P)] = 108[(999.53785-1,000)/1,000 + (1,000.46243-1,000)/1,000)] = 28 ©McGraw-Hill Education. Ch 9-56 Contingent Claims Interest rate changes also affect value of (off-balance sheet) derivative instruments Duration gap hedging strategy must include the effects on off-balance sheet items, such as futures, options, swaps, and caps, as well as other contingent claims ©McGraw-Hill Education. Ch 9-57

Asset and Liability Manangement

FIN6102

Ferriter Spring 2018

Overview
This chapter discusses types and characteristics of loans made by U.S. FIs, models for measuring credit risk, and applicable technological advances.
Important for purposes of:
Pricing loans and bonds
Setting limits on credit risk exposure
Ch 10-2
©McGraw-Hill Education.

Objectives for Individual Loans
There are two primary questions that need to be answered about individual loans.
First, what is the potential return on the loan
Second, what is the probability of default
What options do we have to measure the probability of default?

Why is credit risk important?
Credit Risk is perhaps the most important consideration for a loan.
Loans have a fixed and defined payment, this means that there is very limited upside and more downside compared to equity investments
Because of the greater emphasis on downside risk, bond and loan markets are very focused and very responsive to changes.

Credit Quality Problems
Problems with junk bonds, LDC loans, and residential and farm mortgage loans
Late 1990s, credit card and auto loans
Crises in other countries such as Argentina, Brazil, Russia, and South Korea
2006-2007, mortgage delinquencies on subprime loans surged
Emphasizes importance credit risk analysis
Ch 10-5
©McGraw-Hill Education.

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Credit Quality Problems
Over the early to mid 1990s, improvements in NPLs for large banks and overall credit quality
Late 1990s and early 2000, Telecommunication and tech companies
DotCom bubble – get big fast
WorldCom
Alan Greenspan – raises interest rates
Mid 2000s, economic growth accompanied by reduction in NPL rates
Mortgage crisis
Increased emphasis on credit risk evaluation
Ch 10-6
©McGraw-Hill Education.

What is a junk bond?
Many investors incorporate bondsinto their portfolios to benefit from the interest payments they typically provide. But a bond’s investment value is only as good as its issuer’s ability to make those payments. When a bond’s credit rating falls below what’s considered investment-grade level, it’s referred to as a junk bond.
Though junk bonds carry more risk than investment-grade bonds with higher ratings, they tend to offer much higher yields, and as such, they’re an attractive option for some buyers.
Bonds that have a high enough credit rating are considered investment-grade, which means that they’re suitable for most investors. On the other hand, bonds with a low enough rating are considered non-investment-grade, or junk.
There are three major ratings agencies used to evaluate bonds’ creditworthiness: Standard & Poor’s (S&P), Moody’s and Fitch
These agencies analyze a number of factors, such as assets, liabilities, and cash flow management, when assigning ratings to issuers. S&P and Fitch use a similar ratings system where issuers can receive as high a rating as AA, and as low a rating as D. Moody’s uses a slightly different system where issues can go as high as Aaa and as low as C. A bond that carries a credit rating of BB or lower by S&P and Fitch, or Ba or lower by Moody’s, is considered non-investment-grade, or junk.

Junk Bond Crisis
From the 1970’s to the 1980’s the junk bond market grew exponentially at a a pace of around 34% per year. During this period of time junk bonds achieved a superior risk adjusted return. Essentially, junk bonds in this period were a superior investment compared to other investments with the same amount of risk.
However, this period of growth came to a sudden stop in 1989. There is some disagreement as to what caused it, but most point to the collapse of the US$6.75bn buyout of UAL as the main trigger. A buyout group consists of pilots union and an investment bank sought to take United Airlines private for $6.79 billion couldn’t secure the necessary loans.
Others point to the Ohio Mattress fiasco, a deal that would become known as “burning bed” and remains widely considered to be among the worst deals in modern finance. The Cleveland-based company that Gibbons, Green bought for $1.1 billion in April amid criticism that it was wildly overpaying. In August, Gibbons, Green had to shelve its efforts to line up permanent financing for the acquisition when investors in the high-risk, high-yield ”junk bond” market refused to buy the bonds
The culmination of the crash is considered to be the collapse of Drexel Burnham Lambert, which was forced into bankruptcy in early 1990, largely due to its heavy involvement in junk bonds. At one point it had been the fifth-largest investment bank in the US.

Credit Card and Auto Collapse
At the close of the 1990s, against the backdrop of the economic boom, many low- and moderate-income families were struggling financially and taking on credit card debt at rates unprecedented in American history. There is growing evidence that a combination of structural and economic trends coupled with abusive credit card industry practices left working families with few options other than to borrow heavily.
Between 1989 and 2001, credit card debt in America almost tripled, from $238 billion to $692 billion. The savings rate steadily declined, and the number of people filing for bankruptcy jumped 125 percent.
During the 1990s, the average American family experienced a 53 percent increase in credit card debt, from $2,697 to $4,126 (all figures measured in 2001 dollars). Low-income families saw the largest increase—a 184 percent rise in their debt—but even very high-income families had 28 percent more credit card debt in 2001 than they did in 1989.
With an increase in bankruptcy filings, it led to the drafting of a bankruptcy reform bill, which was considered by the Congress, and passed as Bankruptcy Abuse Prevention and Consumer Protection Act of 2005. It made filing chapter 7 (liquidating) bankruptcy, more difficult and introduced a means-test.

Effects of Deregulation
Since the late 1970s, America’s credit card industry has enjoyed a period of steady deregulation. Two Supreme Court rulings, the first in 1978 and the second in 1996, effectively hobbled state usury laws that protected consumers from excessively high interest rates and fees.
Aggressive Marketing
Relentless Credit Extension.
Between 1993 and 2000, the industry more than tripled the amount of credit it offered to customers, from $777 billion to almost $3 trillion.
Lowering of Minimum Payment Requirements
The amount of their balance customers can pay without incurring a penalty—dropped from 5 percent to only 2 or 3 percent, making it easier for consumers to carry more debt. Assuming an interest rate of 15 percent, it would now take more than 30 years to pay off a credit card balance of $5,000 by making the minimum payment. Or sometimes, never.
Skyrocketing Late Fees and Penalties.
Late fees have become the fastest growing source of revenue for the industry, jumping from $1.7 billion in 1996 to $7.3 billion in 2001. Late fees now average $29, and most cards have reduced the late payment grace period from 14 days to 0 days. In addition to charging late fees, the major card companies use the first late payment as an excuse to cancel low, introductory rates—often making a zero percent card jump to between 22 and 29 percent.

Asian Financial Crisis
The Asian Financial Crisis occurred in 1997 and affected Indonesia, South Korea, Thailand, Hong Kong, Laos, Malaysia and the Philippines. Indonesia, South Korea, Thailand being the most affected.
The causes are disputed but most agree that current account deficits, foreign currency denominated debt and a fixed exchange rate contributed to the crisis. In the mid-1990s, the maintenance of fixed exchange rates encouraged external borrowing and led to excessive exposure to foreign exchange risk in both the financial and corporate sectors.
Most recognize the devaluation of the Chinese Renminbi, the devaluation of the Japanese Yen as a result of the Plaza accord and a strengthen US dollar and a rise in US interest rates as triggers for the collapse.

Asian Financial Crisis
This made the United States a more attractive investment destination relative to Southeast Asia, which had been attracting hot money flows through high short-term interest rates, and raised the value of the U.S. dollar. For the Southeast Asian nations which had currencies pegged to the U.S. dollar, the higher U.S. dollar caused their own exports to become more expensive and less competitive in the global markets.
The resulting panic among lenders led to a large withdrawal of credit from the crisis countries, causing a credit crunch and further bankruptcies. In addition, as foreign investors attempted to withdraw their money, the exchange market was flooded with the currencies of the crisis countries, putting depreciative pressure on their exchange rates. To prevent currency values collapsing, these countries’ governments raised domestic interest rates to exceedingly high levels (to help diminish flight of capital by making lending more attractive to investors), and to intervene in the exchange market – buying up any excess domestic currency at the fixed exchange rate with foreign reserves. Neither of these policy responses could be sustained for long.

Thailand
On 14 May and 15 May 1997, the Thai baht was hit by massive speculative attacks. However, Thailand lacked the foreign reserves to support the USD–Baht currency peg, and the Thai government was eventually forced to float the Baht, on 2 July 1997, allowing the value of the Baht to be set by the currency market.
As a result of high interest rates, Thailand’s booming economy came to a halt amid massive layoffs in finance, real estate, and construction that resulted in huge numbers of workers returning to their villages in the countryside and 600,000 foreign workers being sent back to their home countries. The baht devalued swiftly and lost more than half of its value. The baht reached its lowest point of 56 baht to the U.S. dollar in January 1998. The Thai stock market dropped 75%.

Indonesia
In July 1997, when Thailand floated the baht, Indonesia’s monetary authorities widened the rupiah currency trading band from 8% to 12%. The rupiah suddenly came under severe attack in August. On 14 August 1997, the managed floating exchange regime was replaced by a free-floating exchange rate arrangement. The rupiah dropped further.
Although the rupiah crisis began in July and August 1997, it intensified in November when the effects of that summer devaluation showed up on corporate balance sheets. Companies that had borrowed in dollars had to face the higher costs imposed upon them by the rupiah’s decline, and many reacted by buying dollars through selling rupiah, undermining the value of the latter further. Before the crisis, the exchange rate between the rupiah and the dollar was roughly 2,600 rupiah to 1 U.S. dollar. The rate plunged to over 11,000 rupiah to 1 U.S. dollar on 9 January 1998, with spot rates over 14,000 during 23–26 January and trading again over 14,000 for about six weeks during June–July 1998. On 31 December 1998, the rate was almost exactly 8,000 to 1 U.S. dollar. Indonesia lost 13.5% of its GDP that year.

South Korea
The banking sector was burdened with non-performing loans as its large corporations were funding aggressive expansions. During that time, there was a haste to build great conglomerates to compete on the world stage. Many businesses ultimately failed to ensure returns and profitability. The chaebol, South Korean conglomerates, simply absorbed more and more capital investment. Eventually, excess debt led to major failures and takeovers.
In the wake of the Asian market downturn, Moody’s lowered the credit rating of South Korea on 28 November 1997, and downgraded again on 11 December. That contributed to a further decline in South Korean shares since stock markets were already bearish in November. The Seoul stock exchange fell by 4% on 7 November 1997. On 8 November, it plunged by 7%, its biggest one-day drop to that date. And on 24 November, stocks fell a further 7.2% on fears that the IMF would demand tough reforms. In 1998, Hyundai Motors took over Kia Motors. Samsung Motors’ $5 billion venture was dissolved due to the crisis, and eventually Daewoo Motors was sold to the American company General Motors (GM).
The IMF provided US$57 billion as a bailout package. In return, Korea was required to take restructuring measures. The ceiling on foreign investment in Korean companies was raised from 26 percent to 100 percent. In addition, the Korean government started financial sector reform program. Under the program, 787 insolvent financial institutions were closed or merged by June 2003.
The South Korean won, meanwhile, weakened to more than 1,700 per U.S. dollar from around 800, but later managed to recover. South Korea’s national debt-to-GDP ratio more than doubled (approximately 13% to 30%) as a result of the crisis.

What is the current account?
The components of the current account: goods, services, income and current transfers.
1.     Goods – These are movable and physical in nature, and for a transaction to be recorded under “goods,” a change of ownership from/to a resident (of the local country) to/from a non-resident (in a foreign country) has to take place. Movable goods include general merchandise, goods used for processing other goods, and non-monetary gold. An export is marked as a credit (money coming in), and an import is noted as a debit (money going out).
2.     Services – These transactions result from an intangible action such as transportation, business services, tourism, royalties or licensing. If money is being paid for a service, it is recorded like an import (a debit), and if money is received, it is recorded like an export (credit).
3.     Income – Income is money going in (credit) or out (debit) of a country from salaries, portfolio investments (in the form of dividends, for example), direct investments or any other type of investment. Together, goods, services, and income provide an economy with fuel to function. This means that items under these categories are actual resources that are transferred to and from a country for economic production.
4.     Current Transfers – Current transfers are unilateral transfers with nothing received in return. These include workers’ remittances, donations, aids and grants, official assistance and pensions. Due to their nature, current transfers are not considered real resources that affect economic production.

Mortgage Crisis of 2008
The immediate cause or trigger of the crisis was the bursting of the United States housing bubble which peaked in approximately 2005–2006. An increase in loan incentives such as easy initial terms and a long-term trend of rising housing prices had encouraged borrowers to assume risky mortgages in the anticipation that they would be able to quickly refinance at easier terms.
However, once interest rates began to rise and housing prices started to drop moderately in 2006–2007 in many parts of the U.S., borrowers were unable to refinance. Defaults and foreclosure activity increased dramatically as easy initial terms expired, home prices fell, and adjustable-rate mortgage (ARM) interest rates reset higher.
Several other factors set the stage for the rise and fall of housing prices, and related securities widely held by financial firms. In the years leading up to the crisis, the U.S. received large amounts of foreign money from fast-growing economies in Asia and oil-producing/exporting countries. This inflow of funds combined with low U.S. interest rates from 2002 to 2004 contributed to easy credit conditions, which fueled both housing and credit bubbles. Loans of various types (e.g., mortgage, credit card, and auto) were easy to obtain and consumers assumed an unprecedented debt load.

Ch 10-18
ARMs’ Share of Total Loans Closed, 1987-2014
©McGraw-Hill Education.

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Ch 10-19
Annual Net Charge-Off Rates on Loans
©McGraw-Hill Education.

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Ch 10-20
Nonperforming Asset Ratio for U.S. Commercial Banks
©McGraw-Hill Education.

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Types of Loans
C&I loans: secured and unsecured
Syndication
Spot loans, loan commitments
Decline in C&I loans originated by commercial banks and growth in commercial paper market
Effect of financial crisis on commercial paper market
RE loans: Primarily mortgages
Fixed-rate, ARMs
Mortgages can be subject to default risk when loan-to-value rises and house prices fall below amount of loan outstanding
Ch 10-21
©McGraw-Hill Education.

Individual (Consumer) Loans
Consumer loans: personal, auto, credit card
Nonrevolving loans
Automobile, mobile home, personal loans
Revolving loans
Credit card debt (i.e., Visa, MasterCard)
Proprietary cards, such as Sears and AT&T
Risks affected by competitive conditions and usury ceilings
Bankruptcy Reform Act of 2005
High default rates during finance crisis highlight the importance of risk evaluation prior to making a credit decision
Ch 10-22
©McGraw-Hill Education.

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Other Loans
Other loans include:
Farm loans
Other banks
Nonbank FIs, such as broker margin loans
Foreign banks and sovereign governments
State and local governments
Municipal bankruptcies
Detroit,MI Central Falls, RI, Harrisburg, PA
Ch 10-23
©McGraw-Hill Education.

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Calculating Return on a Loan
Factors: Interest rate, fees, credit risk premium, collateral, and other nonprice terms, such as compensating balances and reserve requirements
Return = inflow/outflow
1+k = 1+(of + (BR + ø))/(1-[b(1-RR)])
Ch 10-24
©McGraw-Hill Education.

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k is the promised gross return
of = direct fees (origination fees)
BR + ø = loan interest rate
b= Compensating balance
RR = Reserve Rate
Note that the text displays 1+ E(r) = p(1+k) + (1-p)0 but this simplifies to the form displayed above.

Return on Loan Equation
Return = inflow/outflow
1+k = 1+(of + (BR + ø))/(1-[b(1-RR)])
Of = origination fee, this is the fee paid by the customer to initiate and process the loan application
BR = Base rate
Ø = risk premium of the customer
b = compensating balance requirement
RR = reserve requirement
k = the gross return on the loan

Example 10-1
Suppose a Bank does the following
Sets a loan rate of 10% (BR = 6% and Ø =4%)
Charges a .125% origination fee
Imposes an 8% compensating balance requirement to be held in non-interest accounts
Sets aside reserves of 10% per Federal Reserve
1 + k = 1 + (.00125+ (.06+.04))/(1-(.08)(.9)
1 + k = 1 + (.10125)/(.928)
1 + k = 1.1091
k = .1091 or 10.91%

Expected Return on a Loan
Expected return: 1 + E(r) = p(1+k) + (1- p) 0
where p equals probability of complete repayment
1- p is the probability of non-payment or default
This can be considered and binomial option as there are only two possible outcomes
It’s important to note that Ø and p are not completely independent
Loan originators consider the probability of default when setting the risk premium. This is to compensate for default risk
To an extent it can be self-reinforcing, high interest rates equal higher payments, all else equal
Higher fixed payments increases the likelihood of default which leads to higher interest rates
Note that realized and expected return may not be equal

Example
Calculate the promised return (k) on a loan if the base rate is 13%, the risk premium is 2%, the compensating balance requirement is 5%, origination fees are .5% and the reserve requirement is 10%
1+k = 1+(of + (BR + ø))/(1-[b(1-RR)])
1+k = 1 +((.005+(.13+.02))/(1-[.05(.9))
1+k = 1+.155/ .955
1 + k = 1.1623
What is the expected return on the loand is the probability of default is 5%

Retail versus Wholesale Credit Decisions
At retail
Usually a simple accept/reject decision rather than adjustments to the rate
Credit rationing
If accepted, customers sorted by loan quantity
For mortgages, discrimination occurs via loan-to-value rather than adjusting rates
At wholesale
Use both quantity and pricing adjustments
Ch 10-29
©McGraw-Hill Education.

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Managing Credit Quality
How do banks and financial institutions manage individual loan quality?
Most banks have guidelines for various loan types
Some guidelines come from outside the organization, others are internally developed
Many banks use benchmarks rating to ensure market competitiveness and market share
All banks have some form of Risk Model to estimate exposure to default risk

Risk Models
Availability, quality, and cost of information are critical factors in credit risk assessment
Facilitated by technology and information
Qualitative models consider borrower specific factors as well as market, or systematic, factors
Borrowed-specific factors include reputation, leverage, volatility of earnings, and collateral
Market specific factors include business cycle and interest rate levels
Ch 10-31
©McGraw-Hill Education.

Linear Probability Model
Credit scoring models are quantitative models that use borrower characteristics to gauge an applicant’s probability of default

Major weakness is that estimated probabilities of default can often lie outside of the [0,1] interval
Since superior statistical techniques are readily available, there is rarely justification for employing linear probability models

Ch 10-32
©McGraw-Hill Education.

Altman’s Discriminant Function
Z=1.2X1+ 1.4X2 + 3.3X3 + 0.6X4 + 1.0X5
Critical value of Z = 1.81
X1 = Working capital/total assets ratio
X2 = Retained earnings/total assets ratio
X3 = EBIT/total assets ratio
X4 = Market value equity/ book value of total liabilities
X5 = Sales/total assets ratio
Ch 10-33
©McGraw-Hill Education.

History of Altman Z-Score
The Z-score formula for predicting bankruptcy was published in 1968 by Edward I. Altman, who was, at the time, an Assistant Professor of Finance at New York University.
The formula may be used to predict the probability that a firm will go into bankruptcy within two years. Z-scores are used to predict corporate defaults and an easy-to-calculate control measure for the financial distress status of companies in academic studies. The Z-score uses multiple corporate income and balance sheet values to measure the financial health of a company. There are many variants of the Altman model depending on the nature of the company and industry.
None of the Altman models or other balance sheet-based models are recommended for use with financial companies. This is because of the opacity of financial companies’ balance sheets and their frequent use of off-balance sheet items. Market based estimate are used instead.

Example 10-23
MNO, Inc., a publicly traded manufacturing firm, has provided the following financial information in its application for a loan.

Assets Liabilities and Equity
Cash $ 20 Accounts payable $ 30
Accounts receivables 90 Notes payable 90
Inventory 90 Accruals 30
Long-term debt 150
Plant and equipment 500 Equity (ret. earnings = $0) 400
Total assets $700 Total liabilities and equity $700

Also assume sales = $500,000 cost of goods sold = $360,000 taxes = $56,000 interest payments = $40,000 net income = $44,000 the dividend payout ratio is 50 percent, and the market value of equity is equal to the book value.

Part a
What is the Altman discriminant function value for MNO, Inc.? Recall that:

Net working capital = Current assets – Current liabilities.
Current assets = Cash + Accounts receivable + Inventories.
Current liabilities = Accounts payable + Accruals + Notes payable.
EBIT = Revenues ‑ Cost of goods sold ‑ Depreciation.
Net income = EBIT ‑ interest ‑ taxes.
Retained earnings = Net income (1 ‑ Dividend payout ratio

Part A solution
Altman’s discriminant function is given by: Z = 1.2X1 + 1.4X2 + 3.3X3 + 0.6X4 + 1.0X5

X1 = (20+90+90‑30‑30-90)/ 700 = .0714 X1 = Working capital/total assets (TA)
X2 = 44(1-.5) / 700 = .0314 X2 = Retained earnings/TA
X3 = (500-360) / 700 = .20 X3 = EBIT/TA
X4 = 400 / 150 = 2.67 X4 = Market value of equity/long term debt
X5 = 500 / 700 = .7143 X5 = Sales/TA
Z = 1.2(0.07) + 1.4(0.03) + 3.3(0.20) + 0.6(2.67) + 1.0(0.71) = 3.104
= .0857 + .044 + .66 + 1.6 + .7143 = 3.104

Part b
Based only on the Altman’s Z-score, should you approve MNO, Inc.’s application to your bank for a $500,000 capital expansion loan?

Since the Z-score of 3.104 is greater than 2.99, ABC Inc.’s application for a capital expansion loan should be approved.

Part c
If sales for MNO were $300,000, the market value of equity were only half of book value, and all other values are unchanged, would your credit decision change?

ABC’s EBIT would be $300,000 – $360,000 = -$60,000.

X1 = (20 + 90 + 90 ‑ 30 ‑ 30 ‑ 90) / 700 = .0714
X2 = 22 / 700 = 0.0314
X3 = ‑60 / 700 = ‑0.0857
X4 = 200 / 150 = 1.3333
X5 = 300 / 700 = 0.4286

Z = 1.2(0.0714) + 1.4(0.0314) + 3.3(-0.0857) + 0.6(1.3333) + 1.0(0.4286) = 1.0754

Since ABC’s Z‑score falls to 1.0754 < 1.81, credit should be denied. Part d Would the discriminant function change for firms in different industries? Would the function be different for retail lending in different geographic sections of the country? What are the implications for the use of these types of models by FIs? Discriminant function models are very sensitive to the weights for the different variables. Since different industries have different operating characteristics, a reasonable answer would be yes with the condition that there is no reason that the functions could not be similar for different industries. In the retail market, the demographics of the market play a big role in the value of the weights. For example, credit card companies often evaluate different models for different areas of the country. Because of the sensitivity of the models, extreme care should be taken in the process of selecting the correct sample to validate the model for use. Logit Model Logit models Overcomes weakness of the linear probability model by restricting the estimated range of default probabilities from the linear regression model to lie between 0 and 1 Quality of credit scoring models have improved, providing positive impact on controlling write-offs and default Ch 10-41 ©McGraw-Hill Education. 41 Linear Discriminant Model Problems associated with discriminant analysis model: Only considers two extreme cases (default/no default) No reason to expect that the weights in a credit scoring model will be constant long-term; sensitivity to variable weights Ignores hard to quantify factors, including business cycle effects and reputation Database of defaulted loans is not available to benchmark the model Ch 10-42 ©McGraw-Hill Education. 42 Newer methods of modeling Default Risk Newer models of credit risk use a combination of financial theory and financial data to infer the possibility of default. Because of the use of financial data these are primarily used to model the credit risk of large corporate firms. Term Structure of credit risk Mortality Rate models RAROC – Risk Adjusted Return on Capital Models Option Models – Black-Scholes Term Structure Derivation of Credit Risk If the risk premium is known, we can infer the probability of default Risk premium can be computed using Treasury strips and zero-coupon corporate bonds p (1+ k) = 1+ i Ch 10-44 ©McGraw-Hill Education. 44 Implied Probability of Default By looking at the spread between Treasury Strips and zero-coupon corporate bonds, we can ascertain the implied probability of default. By comparing a risk-free asset to a risky asset we’ll be able to impute the difference in perceived credit risk One of the major assumptions is that there is no potential for arbitrage. p (1+ k) = 1+ i p(1+k) = Expected return on the loan: p is the probability of repayment and 1-p is the probability of default 1 + i = the risk free rate if i = 2.05% and k = 7.80% then p = (1+i)/(1+k) and 1.0205/1.078 = .94967 and 1-p = .0575 or 5.75% 10-32 The bond equivalent yields for Government of Canada and A-rated corporate bonds with maturities of 93 and 175 days are given below: Bond Maturities 93 days 175 days Government 8.07% 8.11% A-rated corporate 8.42% 8.66% Spread 0.35% 0.55% What are the implied forward rates for both an 82-day Government of Canada and an 82-day A-rated bond beginning in 93 days? Use daily compounding on a 365-day year basis. Part A The forward rate, f, for the period 93 days to 175 days, or 82 days, for the Government of Canada is: (1 + 0.0811)175/365 = (1 + 0.0807)93/365 (1 + f )82/365  f = 8.16 percent The forward rate, f, for the corporate bond for the 82-day period is: (1 + 0.0866)175/365 = (1 + 0.0842)93/365 (1 + f )82/365  f = 8.933% Part B What is the implied probability of default on A-rated bonds over the next 93 days? Over 175 days? The probability of repayment of the 93-day A-rated bond is: p(1 + 0.0842)93/365 = (1 + 0.0807)93/365  p = 99.92 percent Therefore, the probability of default is (1 - p) = (1 - .9992) = 0.0008 or 0.08 percent. The probability of repayment of the 175-day A-rated bond is: p(1 + 0.0866)175/365 = (1 +0.0811)175/365  p = 99.76 percent Therefore, the probability of default is (1 - p) = (1 - .9976) = 0.0024 or 0.24 percent Part C What is the implied default probability on an 82-day A-rated bond to be issued in 93 days? The probability of repayment of the A-rated bond for the period 93 days to 175 days, p, is: p (1.08933)82/365 = (1 + 0.0816)82/365  p = .9984, or 99.84 percent Therefore, the probability of default is (1 - p) or 0.0016 or 0.16 percent. Mortality Rate Models Similar to the process employed by insurance companies to price policies; the probability of default is estimated from past data on defaults Marginal Mortality Rates: MMR1 = (Value Grade B default in year 1) (Value Grade B outstanding yr.1) MMR2 = (Value Grade B default in year 2) (Value Grade B outstanding yr.2) Has many of the problems associated with credit scoring models, such as sensitivity to the period chosen to calculate the MMRs Ch 10-50 ©McGraw-Hill Education. 50 Monthly Mortality The first table below is a schedule of historical defaults (yearly and cumulative) experienced by an FI manager on a portfolio of commercial and mortgage loans. Years after Issuance Loan Type 1 Year 2 Years 3 Years 4 Years 5 Years Commercial: Annual default 0.00% ______ 0.50% ______ 0.30% Cumulative default ______ 0.10% ______ 0.80% ______ Mortgage: Annual default 0.10% 0.25% 0.60% ______ 0.80% Cumulative default ______ ______ ______ 1.64% ______ 10-34 Complete the blank spaces in the table. Commercial: Annual default 0.00%, 0.10%, 0.50%, 0.20%, and 0.30% Cumulative default: 0.00%, 0.10%, 0.60%, 0.80%, and 1.10% Mortgage: Yearly default 0.10%, 0.25%, 0.60%, 0.70%, and 0.80% Cumulative default 0.10%, 0.35%, 0.95%, 1.64%, and 2.43% Note: The annual survival rate is pt = 1 – annual default rate, and the cumulative default rate for n = 4 of mortgages is 1 – (p1* p2* p3* p4) = 1 – (0.999*0.9975*0.9940*0.9930). Part b What are the probabilities that each type of loan will not be in default after 5 years? The cumulative survival rate is = (1-mmr1)*(1-mmr2)*(1-mmr3)*(1-mmr4)*(1-mmr5) where mmr = marginal mortality rate Commercial loan = (1-0.)*(1-0.001)*(1-0.005)*(1-0.002)*(1-0.003) = 0.989 or 98.9%. Mortgage loan = (1-0.001)*(1-0.0025)*(1-0.006)*(1-0.007)*(1-0.008) = 0.9757 or 97.57%. Part C What is the measured difference between the cumulative default (mortality) rates for commercial and mortgage loans after four years? Looking at the table, the cumulative rates of default in year 4 are 0.80% and 1.64%, respectively, for the commercial and mortgage loans. Another way of estimation is: Cumulative mortality rate (CMR) = 1- (1 - mmr1)(1 - mmr2)(1 - mmr3)(1 - mmr4) For commercial loan = 1- (1 - 0.0010)(1 - 0.0010)(1 - 0.0020)(1 - 0.0050) = 1- .9920 = 0.0080 or 0.80 percent. For mortgage loan = 1- (1 - 0.0010)(1 - 0.0025)(1 - 0.0060)(1 - 0.0070) = 1- .98359 = 0.01641 or 1.641 percent. The difference in cumulative default rates is 1.641 - .80 = .8410 percent. RAROC Models Risk-adjusted return on capital One of the most widely used models RAROC = (One year NI on a loan)/(loan risk) Loan risk estimated from loan default rates, or using duration The idea is that a loan should only be made if the income from the loan will lead to an equity increase for the financial institution The most commonly used denominator for loan risk is duration Ch 10-55 ©McGraw-Hill Education. 55 Using Duration to Estimate Loan Risk For denominator of RAROC, duration approach used to estimate loss in value of the loan: LN /LN = -DLN x (R/(1+R)) Ch 10-56 ©McGraw-Hill Education. 56 RAROC Example RAROC = (One year NI on a loan)/(loan risk) One year NI on a loan = (Spread + fees) x Dollar Value of the Loan FI wants to evaluate the credit risk of a $1million loan with a duration of 2.7 years. The expected change in interest rate is 1.1%. And the current interest rate is 5% Given this information the loan/capital risk is: -DLN x (R/(1+R)) -2.7(1,000,000((.011/.05)) = -$28,286 Given that the spread is .2% and the fees associated with the loan are .1% What is the One year NI on the loan (.002+.001) x (1,000,000) = 3,000 With this information 3,000/28,286 = 10.61% Note: When we describe change we drop the negative sign If the RAROC is above the internal benchmark, then the loan should be approved. 10-38 A bank is planning to make a loan of $5,000,000 to a firm in the steel industry. It expects to charge a servicing fee of 50 basis points. The loan has a maturity of 8 years and a duration of 7.5 years. The cost of funds (the RAROC benchmark) for the bank is 10 percent. Assume the bank has estimated the maximum change in the risk premium on the steel manufacturing sector to be approximately 4.2 percent, based on two years of historical data. The current market interest rate for loans in this sector is 12 percent. Part A Using the RAROC model, determine whether the bank should make the loan. RAROC = Fees and interest earned on loan/ Loan or capital risk Loan risk, or LN = -DLN*LN*(R/(1 + R) = = -7.5 * $5m * (.042/1.12) = -$1,406,250 Expected interest = 0.12 x $5,000,000 = $600,000 Servicing fees = 0.0050 x $5,000,000 = $25,000 Less cost of funds = 0.10 x $5,000,000 = -$500,000 Net interest and fee income = $125,000 RAROC = $125,000/1,406,250 = 8.89 percent. Since RAROC is lower than the cost of funds to the bank, the bank should not make the loan. Part B What should be the duration in order for this loan to be approved? For RAROC to be 10 percent, loan risk should be: $125,000/LN = 0.10  LN = 125,000 / 0.10 = $1,250,000  -DLN * LN * (R/(1 + R)) = 1,250,000 DLN = 1,250,000/(5,000,000 * (0.042/1.12)) = 6.67 years. Thus, this loan can be made if the duration is reduced to 6.67 years from 7.5 years. Option Models Employ option pricing methods to evaluate the option to default Used by many of the largest banks to monitor credit risk KMV Corporation markets this model widely Ch 10-61 ©McGraw-Hill Education. 61 Option Framework The option framework holds that when borrowing a borrower has two options, to repay the loan or to default. Similar to financial options, these real options have value. In a sense, the borrower has only the loss of its invested equity, but maintains upside if the company goes well. Thus the decision to borrow, can be modeled much like a call option. The most famous model for options valuation is Black-Scholes, which we will be applying here. Applying Option Valuation Model Merton showed value of a risky loan: L() = Be-i[(1/d)N(h1) +N(h2)] Written as a yield spread: k() - i = (-1/)ln[N(h2) +(1/d)N(h1)] where k() = Required yield on risky debt ln = Natural logarithm i = Risk-free rate on debt of equivalent maturity Remaining time to maturity Ch 10-63 ©McGraw-Hill Education. 63 Black-Scholes Option Pricing Model Model used to value European options: Ch 10-64 ©McGraw-Hill Education. 64 Where: C = call option price S = price on the asset underlying the option E = exercise price of the option r = riskless rate of interest over one year Sigma = standard dev of the underlying asset’s return T = time to expiration of the option as a fraction of one year e = base of the natural logarithm, or the exponential function Ln (S/E) = natural log of S/E N(d) = value of the cumulative normal distribution evaluated at d1 and d2 Model Assumptions Capital markets are frictionless Constant variability in underlying asset’s return Log normal probability distribution of underlying asset’s price Constant risk-free rate that is known over time No dividends on underlying asset No early exercise on option Ch 10-65 ©McGraw-Hill Education. 65 Formula continued H1=-[(1/2)ơ2 -ln(d)/ơ√  H2=-[(1/2)ơ2 +ln(d)/ơ√  10-40 A firm is issuing a two-year debt in the amount of $200,000. The current market value of the assets is $300,000. The risk-free rate is 4 percent, and the standard deviation of the rate of change in the underlying assets of the borrower is 20 percent. Using an options framework, determine the following: a. The current market value of the loan. b. The risk premium to be charged on the loan. Answer The following need to be estimated first: d, h1 and h2 . d = Be-iτ /A = $200,000e-0.04(2)/300,000 = 0.6154 or 61.54 percent. h1 = -[0.5 x (0.20)2 x 2 - ln(0.6154)]/(0.20)(2)1/2 = -1.8578 h2 = -[0.5*(0.20)2 *2 + ln(0.6154)]/(0.20)(2)1/2 = 1.5750 Current market value of loan = l(τ) = Be-iτ [N(h1)1/d + N(h2)] = $184,623.27[N(-1.8578) x 1.62493 + N(1.5750)] = $184,623.27[1.62493 x 0.031654 + 0.94265] = $183,531 The risk premium, ϕ = k(τ) – i = (-1/τ) ln[N(h2) + (1/d)N(h1)] = (-½)ln[0.94265 + 1.62493 x 0.031654] = 0.002966 = 0.2966% Credit Analysis and Loan Underwriting Real Estate Lending Two considerations dominate FI’s decision to approve mortgage application: Applicant’s ability and willingness to make timely interest and principal repayments Value of borrower’s collateral Ch 10-69 ©McGraw-Hill Education. 69 Real Estate Lending Determining a customer’s ability to maintain mortgage payments: GDS = (Annual mortgage payments + Property taxes) / Annual gross income TDS = Annual total debt payments / Annual gross income Ch 10-70 ©McGraw-Hill Education. 70 Lending Consumer and small-business Similar techniques as mortgage loans Mid-market commercial and industrial Annual sales revenues from $5 million to $100 million, recognizable corporate structure, but no access to liquid capital markets 5 C’s of credit are: character, capacity, collateral, conditions, and capital Ch 10-71 ©McGraw-Hill Education. 71 å = + = n j j i j i X PD 1 , error b

Asset and Liability Management

Fin6102

Ferriter – Spring 2018

Agenda
Review Questions from Last Week
Depository Institutions
Security Brokers and Investment Firms
Insurance
Finance Companies

Overview of Depository Institutions
This chapter recognizes three major FI groups:
Commercial banks, savings institutions, and credit unions
This chapter discusses depository FIs:
Size, structure, and composition
Balance sheets and recent trends
Regulation of depository institutions
Depository institutions performance
Ch 2-3
©McGraw-Hill Education.

Products of U.S. FIs
Comparing the products of FIs in 1950, to products of FIs in 2016:
Much greater distinction between types of FIs in terms of products offered in 1950 than in 2016
Blurring of product lines and services over time and wider array of services
(Refer to Tables 2-1A and 2-1B in the text)
Ch 2-4
©McGraw-Hill Education.

Specialness of Depository FIs
Products offered on both sides of the balance sheet
Offer loans
Asset side
Accept deposits
Liabilities side
Ch 2-5
©McGraw-Hill Education.

Other Outputs of Depository FIs
Other products and services in 1950:
Payment services, savings products, fiduciary services
By 2016, products and services further expanded to frequently include:
Underwriting of debt and equity, insurance and risk management products
Ch 2-6
©McGraw-Hill Education.

Size of Depository FIs
Consolidation has created some very large FIs
Combined effects of disintermediation, global competition, regulatory changes, technological developments, competition across different types of FIs
Ch 2-7
©McGraw-Hill Education.

Largest US Depository Institutions
Ch 2-8
Company Banking Assets Holding Company Assets ($ billions)
J.P. Morgan Chase $2,134.1 $2,448.0
Bank of America 1,629.5 2,152.0
Wells Fargo 1,629.5 1,720.6
Citigroup 1,337.5 1,829.4
U.S. Bancorp 414.0 419.1
PNC Financial Services Corp. 343.6 354.2
Bank of New York Mellon 343.6 395.3
State Street Corp. 289.4 294.6
Capital One 254.4 310.6
TD Bank 252.4 253.2

8
8

Commercial Banks
Largest group of depository institutions
Differ from other FIs in composition of assets and liabilities, as well as regulatory oversight
Large and small commercial banks differ with regards to structure and composition
E.g., larger banks make more commercial/industrial loans and small banks make more real estate loans
Mix of very large banks with very small banks
Ch 2-9
©McGraw-Hill Education.

Structure and Composition
Shrinking number of banks:
14,416 commercial banks in 1985
12,744 in 1989
5,472 in 2015
Mostly the result of Mergers and Acquisitions
M&A prevented prior to 1980s, 1990s
Consolidation has reduced asset share of smallest banks (under $1 billion)
Ch 2-10
©McGraw-Hill Education.

Regulation, Functions & Structure
Functions of depository institutions
Regulatory sources of differences across types of depository institutions
Structural changes generally resulted from changes in regulatory policy
Example: Changes permitting interstate branching
Riegle-Neal Act, 1994
Ch 2-11
©McGraw-Hill Education.

12
12

Commercial Banks:
Asset Concentration
Size 2015
Assets Percent
of Total 1984
Assets Percent
of Total
All FDIC Insured 14,679.2 100.0 2,508.9 100.0
$100M or Less 93.5 6.0 404.2 16.1
$100M – $1B 1,014.7 6.9 513.9 20.5
$1B – $10B 1,336.8 9.1 725.9 28.9
$10B or more 12,234.3 83.4 864.8 34.5

13
13

Structure and Composition
of Commercial Banks
Limited powers to underwrite corporate securities have existed only since 1987
Financial Services Modernization Act 1999
Permitted commercial banks, investment banks, and insurance companies to merge
Ch 2-14
©McGraw-Hill Education.

Composition of
Commercial Banking Sector
Community Banks
Regional or Superregional
Access to federal funds market to finance their lending and investment activities
Money Center Banks
Bank of New York Mellon, Deutsche Bank (Bankers Trust), Citigroup, J.P. Morgan Chase, HSBC Bank USA
Ch 2-15
©McGraw-Hill Education.

Balance Sheet and Trends
Key trends since 1987
Business loans have declined in importance while securities and mortgages have increased
What influences these trends?
Increased importance of alternative funding via commercial paper market
Securitization of mortgage loans
Temporary effects: credit crunch during recessions of 1989-92 and 2001-02
Ch 2-16
©McGraw-Hill Education.

Commercial Banks,
June 2015
Primary assets:
Real Estate Loans: $3,801.9 B
C&I loans: $1,737.6 B
Loans to individuals: $1,301.2 B
Investment security portfolio: $3,953.0 B
Of which, Treasury securities: $2,015.3 B
Credit/default risk is a major exposure
Ch 2-17
©McGraw-Hill Education.

Commercial Banks,
June 2015 Continued
Primary liabilities:
Deposits: $11,108.4 billion
Borrowings: $1,578.2 billion
Other liabilities: $339.1 billion
Inference:
Maturity mismatch/interest rate risk and liquidity risk are key areas of exposure
Ch 2-18
©McGraw-Hill Education.

Terminology
Transaction accounts
Negotiable Order of Withdrawal (NOW) accounts
Money Market Mutual Funds
Negotiable CDs
Ch 2-19
©McGraw-Hill Education.

Equity
Commercial bank equity capital
11.26 percent of total liabilities and equity (2015)
TARP program 2008-2009 intended to encourage increase in capital
Citigroup $25 B
BOA $20 B
Through 2015: $245 B in capital injections through TARP
Ch 2-20
©McGraw-Hill Education.

Off-Balance-Sheet Activities
Heightened importance of off-balance-sheet items
OBS assets, OBS liabilities
Earnings and regulatory incentives
Risk control and risk producing
Role of mortgage backed securities
“Toxic” assets
Expansion of oversight to unregulated OTC derivative securities
Ch 2-21
©McGraw-Hill Education.

Major OBS Activities
Issuing guarantees
E.g., letters of credit
Typically contain an insurance underwriting element
Loan commitments
Derivative transactions
Futures
Forwards
Options
Swaps
Ch 2-22
©McGraw-Hill Education.

Other Fee-Generating Activities
Trust services
Correspondent banking
Services generally sold as a package
Types of services offered:
Check clearing and collection
Foreign exchange trading
Hedging
Participation in large loan and security issuances
Ch 2-23
©McGraw-Hill Education.

Key Regulatory Agencies
FDIC
Deposit Insurance Fund (DIF)
Role in preventing contagious “runs” or panics
OCC: Primary function is to charter (and close) national banks
FRS: Monetary policy, lender of last resort
National banks are automatically members of the FRS; state-chartered banks can elect to become members
State bank regulators
Dual Banking System: Coexistence of national and state-chartered banks
Ch 2-24
©McGraw-Hill Education.

25
25

Legislation, 1927-1956
1927 McFadden Act: Controls branching of national banks
1933 Glass-Steagall: Separates securities and banking activities, established FDIC, prohibited interest on demand deposits
1956 Bank Holding Company Act and subsequent amendments specifies permissible activities and regulation by FRS of BHCs
Ch 2-26
©McGraw-Hill Education.

Legislation, 1970-1978
1970 Amendments to the Bank Holding Company Act: Extension to one-bank holding companies
1978 International Banking Act: Regulated foreign bank branches and agencies in US
Ch 2-27
©McGraw-Hill Education.

Legislation, 1980 – 1982
1980 DIDMCA and 1982 Garn-St. Germain Depository Institutions Act (DIA)
Mainly deregulation acts
Phased out Regulation Q
Authorized NOW accounts nationwide
Increased deposit insurance from $40,000 to $100,000
Reaffirmed limitations on bank powers to underwrite and distribute insurance products
Ch 2-28
©McGraw-Hill Education.

Legislation, 1987-1989
1987 Competitive Equality in Banking Act (CEBA)
Redefined bank to limit growth of nonbank banks
Focus on recapitalization of FSLIC
1989 FIRREA
Imposed restrictions on investment activities
Replaced FSLIC with FDIC-SAIF
Replaced FHLB with Office of Thrift Supervision (OTS)
Created Resolution Trust Corporation (RTC)
Ch 2-29
©McGraw-Hill Education.

Legislation, 1991
1991 FDIC Improvement Act
Introduced prompt corrective action (PCA)
Risk-based deposit insurance premiums
Limited “too big to fail” bailouts by federal regulators
Extended federal regulation over foreign bank branches and agencies in FBSEA
Ch 2-30
©McGraw-Hill Education.

Legislation, 1994
1994 Riegle-Neal Interstate Banking and Branching Efficiency Act
Permits BHCs to acquire banks in other states
Invalidates some restrictive state laws
Permits BHCs to convert out-of-state subsidiary banks to branches of single interstate bank
Newly chartered branches permitted interstate if allowed by state law
Ch 2-31
©McGraw-Hill Education.

Legislation, 1999
1999 Financial Services Modernization Act
Allowed banks, insurance companies, and securities firms to enter each others’ business areas
Provided for state regulation of insurance
Streamlined regulation of BHCs
Prohibited FDIC assistance to affiliates and subsidiaries of banks and savings institutions
Provided for national treatment of foreign banks
Ch 2-32
©McGraw-Hill Education.

Legislation, 2010
2010 Wall Street Reform and Consumer Protection Act
Financial Services Oversight Council created
Government gained power to break up FIs that pose a systemic risk to the system
Consumer Financial Protection Bureau created
GAO to audit Federal Reserve activities
Nonbinding proxy vote on executive pay
Trading via clearinghouse for some derivatives
Ch 2-33
©McGraw-Hill Education.

Industry Performance
Economic expansion and falling interest rates through 1990s
Brief downturn in early 2000s followed by strong performance improvements
Record earnings $106.3 billion 2003
Performance remained stable through mid 2000s as interest rates rose
Late 2000s: Strongest recession since Great Depression
Ch 2-34
©McGraw-Hill Education.

Savings Institutions
Comprised of:
Savings Associations (SAs)
Savings Banks (SBs)
Effects of changes in Federal Reserve’s policy of interest rate targeting combined with Regulation Q and disintermediation
Effects of moral hazard and regulator forbearance
Qualified thrift lender (QTL) test
Ch 2-35
©McGraw-Hill Education.

Savings Institutions: Recent Trends
Industry is smaller overall
Intense competition from other FIs
E.g., mortgages
Ch 2-36
©McGraw-Hill Education.

Primary Regulators
Office of the Comptroller of Currency (OCC)
FDIC-DIF Fund
FDIC oversaw and managed Savings Association Insurance Fund (SAIF)
SAIF and Bank Insurance Fund (BIF) merged in January 2007 to form DIF
Same regulatory structure applied to commercial banks
Ch 2-37
©McGraw-Hill Education.

Credit Unions
Nonprofit DIs owned by member-depositors with a common bond
Specialize in small consumer loans
Exempt from taxes and Community Reinvestment Act (CRA)
Expansion of services offered in order to compete with other FIs
Claim of unfair advantage of CUs over small commercial banks
Ch 2-38
©McGraw-Hill Education.

39
39

Global Issues
Spread of US financial crisis to other countries
Many European banks saved from bankruptcy through support of governments and central banks
Target interest rates at or below 1 percent
Links to macroeconomic performance
Ch 2-40
©McGraw-Hill Education.

Financial Statement Analysis
Return on equity (ROE): measures overall profitability per dollar of equity
Return on assets (ROA): measures profit generated relative to assets
Equity multiplier (EM): measures extent to which assets are funded with equity relative to debt
Profit margin (PM): measures ability to pay expenses and generate net income
Asset utilization (AU): measures amount of interest and noninterest income generated per dollar of total assets
Ch 2-41
©McGraw-Hill Education.

CAMELS Ratings
Composite 1: Institutions are generally sound in every respect
Composite 2: Institutions are fundamentally sound, but may reflect modest weaknesses
Composite 3: Institutions exhibit financial, operational, or compliance weaknesses
Composite 4: Immoderate volume of serious financial weaknesses
Composite 5: Extremely high immediate or near term probability of failure
©McGraw-Hill Education.

Technology in Commercial Banking
Wholesale banking services
E.g., account reconciliation, electronic funds transfer, electronic billing, cloud computing, etc.
Retail banking services
E.g., ATMs, smart cards, online/mobile banking, tablet banking, loyalty programs, etc.
Advanced technology requirements

Asset and Liability Management

Fin6102

Ferriter – Spring 2018

Overview
This chapter discusses securities brokerage firms and investment banks
Activities of securities firms and investment banks
Size, structure, and composition
Balance sheets and recent trends
Regulation of securities firms and investment banks
Global issues
Ch 4-2
©McGraw-Hill Education.

Securities Firms and Investment Banks
Securities firms
Specialize in the purchase, sale, and brokerage of existing securities
Retail
Investment banks
Specialize in originating, underwriting and distributing issues of new securities
Advising on M&As and restructuring
Commercial
Ch 4-3
©McGraw-Hill Education.

Securities Firms and Investment Banks Continued
Growth in domestic M&A:
Less than $200 billion in 1990
$1.83 trillion in 2000
In US: bottomed out at $458 billion in 2002 ($1.2 trillion worldwide)
Topped $1.7 trillion 2007 ($4.5 trillion worldwide)
Effects of financial crisis: fell to $687 billion in 2010 ($1.8 trillion worldwide)
Worst financial crisis since 1930s, but M&A activity still greater than early 2000s
Ch 4-4
©McGraw-Hill Education.

5
5

Structural Changes in Recent Years
Acquisition of Bear Stearns by J.P. Morgan Chase
Bankruptcy of Lehman Brothers
Acquisition of Merrill Lynch by Bank of America
Only two remaining major firms:
Goldman Sachs and Morgan Stanley
Converted to commercial bank holding companies in 2008
Ch 4-6
©McGraw-Hill Education.

7
7

Size, Structure and Composition
Dramatic increase in number of firms from 1980 to 1987
Decline of 37% in the number of firms following the 1987 crash, to year 2006
Concentration of business among the largest firms
Ch 4-8
©McGraw-Hill Education.

Size, Structure and Composition Continued
Many recent interindustry mergers (i.e., insurance companies and investment banks)
Role of Financial Services Modernization Act, 1999
Lehman Brothers, Bear Stearns, Merrill Lynch, Goldman Sachs, and Morgan Stanley gone by end of 2008
Ch 4-9
©McGraw-Hill Education.

Types and Relative Sizes of Firms
National full-line firms are largest
Service retail and corporate clients
Three categories: commercial bank holding companies, national full-line firms, and large investment banks
BOA (via acquisition of Merrill Lynch); Morgan Stanley
National full-line firms specializing in corporate finance are second in size
Goldman Sachs, Salomon Brothers/Smith Barney (Citigroup)
Ch 4-10
©McGraw-Hill Education.

Remainder of industry:
Regional securities firms (subdivided into large, medium, and small)
Specialized discount brokers
Electronic trading firms
Venture capital firms
Other firms
E.g., research boutiques, floor specialists, etc.
Ch 4-11
Types and Relative Sizes of Firms Continued
©McGraw-Hill Education.

12
12

Key Activities
Investment banking
Activities related to underwriting and distributing new (IPOs) and secondary (seasoned) issues of debt and equity
Public and private offerings
Venture Capital
Market making
Involves creating a secondary market
Increasing importance of online trading
Technology risk
Ch 4-13
©McGraw-Hill Education.

Key Activities (Continued)
Trading
Position trading, pure arbitrage, risk arbitrage, program trading, etc.
Investing
Cash management
Mergers and Acquisitions (M&As)
Back-office and service functions
Ch 4-14
©McGraw-Hill Education.

Recent Trends
Decline in trading volume and brokerage commissions
Particularly since crash of 1987, although some recovery since 1992
Record volumes 1995-2000
Resurgence in market values and commissions during mid-2000s
New market value lows in 2008-2009
Commission income also declined
Ch 4-15
©McGraw-Hill Education.

Recent Trends (Continued)
Pretax net income over $9 billion per year between 1996 and 2000
Pretax profits soared to $31.6 billion in 2000
Curtailed by economic slowdown and September 11, 2001 terrorist attacks
Worries over securities law violations and loss of investor confidence
E.g., Enron, Merck, WorldCom, etc.
Financial crisis, 2008
Profits recovered, 2009
Ch 4-16
©McGraw-Hill Education.

17
17

Balance Sheet
Key assets:
Reverse repurchase agreements
Receivables from other broker-dealers
Long positions in securities and commodities
Subject to high levels of market and interest rate risk
Ch 4-18
©McGraw-Hill Education.

Balance Sheet Continued
Key liabilities:
Repurchase agreements are major source of funds
Payables to customers
Payables to other broker-dealers
Securities and commodities sold short
Capital levels much lower than in depository institutions
Ch 4-19
©McGraw-Hill Education.

Regulation
Primary regulator is the Securities and Exchange Commission (SEC)
Reaffirmed by National Securities Markets Improvement Act (NSMIA) of 1996
Prior to NSMIA, regulated by SEC and each state in which the firm operated
Ch 4-20
©McGraw-Hill Education.

Regulation Continued
Early 2000s saw erosion of SEC dominance
Increased vigilance by state attorney generals
Criminal cases brought mainly by states against securities law violators
New York State vs. Merrill Lynch
Spring 2003, $1.4 billion in penalties over investor abuses
New rules brought by SEC for greater disclosure by analysts of potential conflicts of interest
Ch 4-21
©McGraw-Hill Education.

Regulation Concluded
Financial Industry Regulatory Authority (FINRA)
Handles day-to-day regulation
Independent, not-for-profit
Authorized by Congress
Writes and enforces rules governing security firm activities
Enhance transparency in the market
Dark pools
Ch 4-22
©McGraw-Hill Education.

Extension of Oversight
Additional oversight from US Congress
Hearings focused on role of investment banks in the financial crisis
Goldman Sachs bundling of toxic assets
Ch 4-23
©McGraw-Hill Education.

Extension of Oversight Continued
2010 Wall Street Reform and Consumer Protection Act
Financial Services Oversight Council
New authority for Federal Reserve to supervise systemically important firms
Registration limits for advisors changed
Regulation of securitization markets; stronger regulation of credit agencies
Authority for government to resolve nonbank FIs
Ch 4-24
©McGraw-Hill Education.

Extension of Oversight Concluded
Kenneth Feinberg (“pay czar”) given voice as to executive compensation packages

Investor Protection and Other Monitoring
Securities Investor Protection Corporation (SIPC)
Protection level of $500,000
October 2003 implementation of provisions of Patriot Act to combat money laundering
Scrutiny of individual identities and affiliations with terrorists
Ch 4-26
©McGraw-Hill Education.

Global Issues
Global nature of securities firms
Competition between US and European firms
Foreign investors’ transactions in US securities and US investors’ transactions in foreign securities exchanges increased
Global concern about capital, liquidity, and leverage following the financial crisis
Implications for global competitiveness
Strategic alliances
Exit from foreign markets
Ch 4-27
©McGraw-Hill Education.

Pertinent Websites
Federal Reserve
NYSE
SEC
Securities Industry Association
SIPC
FINRA
Ch 4-28

www.federalreserve.gov

www.nyse.com

www.sec.gov

www.sifma.com

www.sipc.org

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