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    Slide 1:GESTIÓN BANCARIA Master en Banca y Finanzas Cuantitativas (QF), 2007 Santiago Carbó Valverde Universidad de Granada

    Slide 3:Santiago Carbó Valverde Universidad de Granada Materiales docentes en:

    Slide 4:Esquema de trabajo: Transparencias en inglés Presentaciones de papers en clase Examen final Referencia básica: SAUNDERS, A. Y M.M. CORNETT (2000): FINANCIAL INSTITUTIONS MANAGEMENT: A MODERN PERSPECTIVE, 4ª EDICIÓN, MCGRAW HILL, NEW YORK, ESTADOS UNIDOS.

    Slide 7:Why study Financial Markets and Institutions? They are the cornerstones of the overall financial system in which financial managers operate Individuals use both for investing Corporations and governments use both for financing

    Slide 8:Overview of Financial Markets Primary Markets versus Secondary Markets Money Markets versus Capital Markets Foreign Exchange Markets

    Slide 9:Primary Markets versus Secondary Markets Primary Markets markets in which users of funds (e.g. corporations, governments) raise funds by issuing financial instruments (e.g. stocks and bonds) Secondary Markets markets where financial instruments are traded among investors (e.g. Bolsa Madrid, NYSE, NASDAQ)

    Slide 10:Money Markets versus Capital Markets Money Markets markets that trade debt securities with maturities of one year or less (e.g. Spanish Government bonds, U.S. Treasury bills) Capital Markets markets that trade debt (bonds) and equity (stock) instruments with maturities of more than one year

    Slide 11:Money Market Instruments Outstanding, 1990-1999 ($Bn)

    Slide 12:Capital Market Instruments Outstanding, 1990-1999 ($Bn)

    Slide 13:Foreign Exchange Markets “FX” markets deal in trading one currency for another (e.g. dollar for yen) The “spot” FX transaction involves the immediate exchange of currencies at the current exchange rate The “forward” FX transaction involves the exchange of currencies at a specified date in the future and at a specified exchange rate

    Slide 14:Overview of Financial Institutions (FIs) Institutions that perform the essential function of channeling funds from those with surplus funds to those with shortages of funds (e.g. banks, thrifts, insurance companies, securities firms and investment banks, finance companies, mutual funds, pension funds)

    Slide 15:Flow of Funds in a World without FIs: Direct Transfer

    Slide 16:Flow of Funds in a world with FIs: Indirect transfer

    Slide 17:Types of FIs Commercial banks depository institutions whose major assets are loans and major liabilities are deposits Thrifts and savings banks depository institutions in the form of savings banks, savings and loans, credit unions, credit cooperatives Insurance companies financial institutions that protect individuals and corporations from adverse events

    Slide 18:Securities firms and investment banks financial institutions that underwrite securities and engage in securities brokerage and trading Finance companies financial institutions that make loans to individuals and businesses Mutual Funds financial institutions that pool financial resources and invest in diversified portfolios Pension Funds financial institutions that offer savings plans for retirement

    Slide 19:Services Performed by Financial Intermediaries Monitoring Costs aggregation of funds provides greater incentive to collect a firm’s information and monitor actions Liquidity and Price Risk provide financial claims to savers with superior liquidity and lower price risk

    Slide 20:Transaction Cost Services transaction costs are reduced through economies of scale Maturity Intermediation greater ability to bear risk of mismatching maturities of assets and liabilities Denomination Intermediation allow small investors to overcome constraints imposed to buying assets imposed by large minimum denomination size

    Slide 21:Services Provided by FIs Benefiting the Overall Economy Money Supply Transmission Depository institutions are the conduit through which monetary policy actions impact the economy in general Credit Allocation often viewed as the major source of financing for a particular sector of the economy (e.g. farming and real estate)

    Slide 22:Intergenerational Wealth Transfers life insurance companies and pension funds provide savers with the ability to transfer wealth from one generation to the next Payment Services efficiency with which depository institutions provide payment services directly benefits the economy

    Slide 23:Risks Faced by Financial Institutions Interest Rate Risk Foreign Exchange Risk Market Risk Credit Risk Liquidity Risk Off-Balance-Sheet Risk Technology Risk Operation Risk Country or Sovereign Risk Insolvency Risk

    Slide 24:Regulation of Financial Institutions FIs provide vital financial services to all sectors of the economy; therefore, their regulation is in the public interest In an attempt to prevent their failure and the failure of financial markets overall

    Slide 25:Globalization of Financial Markets and Institutions Financial Markets became more global as the value of stocks traded in foreign markets soared Foreign bond markets have served as a major source of international capital Globalization also evident in the derivative securities market

    Slide 26:Factors Leading to Significant Growth in Foreign Markets The pool of savings from foreign investors has increased International investors have turned to U.S. and other markets to expand their investment opportunities Information on foreign investments and markets is now more accessible (e.g. internet) Some mutual funds allow ability to invest in foreign securities with low transaction costs Deregulation has enhanced globalization of capital flows

    Slide 28:Why Are Financial Intermediaries Special? Objectives: Develop the tools needed to measure and manage the risks of FIs. Explain the special role of FIs in the financial system and the functions they provide. Explain why the various FIs receive special regulatory attention. Discuss what makes some FIs more special than others.

    Slide 29:Without FIs

    Slide 30:FIs’ Specialness Without FIs: Low level of fund flows. Information costs: Economies of scale reduce costs for FIs to screen and monitor borrowers Less liquidity Substantial price risk

    Slide 31:With FIs

    Slide 32:Financial Structure Puzzles: a way to explain the role of FIs stocks are not the most important source of external financing for businesses issuing debt and equity is not the main way that businesses finance operations indirect financing is more important than direct financing banks are the most important source of external funds for businesses financial industry is one of the most heavily regulated industries only large, well-known firms have access to the securities markets collateral is an important part of debt contracts for businesses and households debt contracts are complex and often contain many restrictions for the borrower

    Slide 33:Transaction Costs information and other transaction costs in financial system can be substantial How do transaction costs affect investing? How can financial intermediaries reduce transaction costs?

    Slide 34:Asymmetric Information one party to a transaction has better information to make decisions than the other party asymmetric information in financial market causes two main problems adverse selection moral hazard

    Slide 35:Adverse Selection asymmetric information problem that occurs prior to a transaction examples of adverse selection result of adverse selection is that lenders may decide not to make loans if they can not distinguish between “good” and “bad” credit risks

    Slide 36:Moral Hazard asymmetric information problem that occurs after a transaction risk that borrower will undertake risky activities that will increase the probability of default result of moral hazard is that lenders may decide not to make a loan

    Slide 37:Lemons Problem idea presented in article by George Akerlof in terms of lemons in used car market used car buyers are unable to determine quality of car - good car or lemon? What amount is buyer willing to pay for this used car of unknown quality? How can buyer improve information on quality?

    Slide 38:Lemons Problem in Stock and Bond Market asymmetric information prevents investors from identifying good and bad firms What price will these investors pay for stock? Who has better information about the firm? Which firms will “come to the market” for financing under these conditions?

    Slide 39:Principal-Agent Problem define the principal-agent problem Who is the principal and who is the agent? What problem does a separation of ownership and control cause? How could we prevent principal-agent problem?

    Slide 40:Solutions to Financing Puzzles lemons or adverse selection problem tells why marketable securities are not the primary source of financing situation is similar in corporate bond market tells why stocks are not the most important source of external financing

    Slide 41:More Solutions to Financial Structure Puzzles importance of financial intermediaries explains importance of indirect financing explains why banks are most important source of external financing explains why markets are only available to large, well-known firms

    Slide 42:Functions of FIs Brokerage function Acting as an agent for investors: e.g. Merrill Lynch, Charles Schwab Reduce costs through economies of scale Encourages higher rate of savings Asset transformer: Purchase primary securities by selling financial claims to households These secondary securities often more marketable

    Slide 43:Role of FIs in Cost Reduction Information costs: Investors exposed to Agency Costs Role of FI as Delegated Monitor (Diamond, 1984) Shorter term debt contracts easier to monitor than bonds FI likely to have informational advantage

    Slide 44:Services Performed by FIs Monitoring Costs Liquidity and Price Risk Transaction Cost Services Maturity Intermediation Denomination Intermediation

    Slide 45:Services Provided by FIs Money Supply Transmission Credit Allocation Intergenerational Wealth Transfers Payment Services

    Slide 46:Regulation of FIs Regulation is not costless Net regulatory burden. Safety and soundness regulation Monetary policy regulation Credit allocation regulation Consumer protection regulation Investor protection regulation Entry regulation

    Slide 47:Changing Dynamics of Specialness Trends in the United States Decline in share of depository institutions. Increases in pension funds and investment companies. May be attributable to net regulatory burden imposed on depository FIs. Technological changes affect delivery of financial services and regulatory issues Potential for regulations to be extended to hedge funds Result of Long Term Capital Management disaster

    Slide 48:Future Trends Weakening of public trust and confidence in FIs may encourage disintermediation Increased merger activity within and across sectors Citicorp and Travelers, UBS and Paine Webber More large scale mergers such as J.P. Morgan and Chase, and Bank One and First Chicago Growth in Online Trading Increased competition from foreign FIs at home and abroad Mergers involving world’s largest banks Mergers blending together previously separate financial services sectors

    Slide 50:“It is the ability to foretell what is going to happen tomorrow, next week, next month, and next year. And to have the ability afterwards to explain why it didn’t happen.” Sir Winston Churchill

    Slide 51:What are Financial Intermediaries (FIs)? Financial Securities: contingent claims on future cash flows – debt, equity, derivatives, hybrids. All firms’ liabilities & net worth are predominately comprised of financial securities. But most firms hold real assets such as inventory, plant & equipment, buildings. FIs’ assets are predominately comprised of financial securities.

    Slide 52:Transparent, Transluscent and Opaque FIs

    Slide 53:What Services Do FIs Provide? Information Liquidity Reduced Transaction Costs Transmission of Monetary Policy Credit Allocation Payment Services Intergenerational Wealth Transfer

    Slide 54:FIs are the most regulated of all firms Safety and Soundness Regulation Deposit Insurance Monetary Policy Regulation Reserve Requirements Credit Allocation Regulation (eg., mortgages) Consumer Protection Regulation Community Reinvestment Act, Home Mortgage Disclosure Act, Truth in Lending Protection Investor Protection Regulation Entry Regulation

    Slide 55:Types of FIs Depository Institutions Insurance Companies Securities Firms and Investment Banks Mutual Funds Finance Companies Distinctions blurred by the Gramm-Leach-Bliley Act of 1999 that created Financial Holding Companies (FHCs).

    Slide 56:Features Common to Most FIs High Amount of Financial Leverage Low equity/assets ratios. Capital requirements. Off-balance sheet items Contingent claims that under certain circumstances may eventually become balance sheet items (ex. Derivatives, commitments) Revenue: Interest Income & Fees Costs: Interest Expenses and Personnel

    Slide 57:Depository Institutions Commercial Banks: accept deposits and make loans to consumers and businesses. Money Center Banks: Citigroup, Bank of NY, BankOne, Bankers Trust (Deutschebank), JP Morgan Chase and HSBC Bank USA. Savings Associations (S&Ls) Qualified Thrift Lender (QTL) mortgages must exceed 65% of thrift’s assets. Savings Banks Use deposits to fund mortgages & other assets. Credit Unions and Credit cooperatives Nonprofit mutually owned institutions (owned by depositors).

    Slide 58:Overview of Depository Institutions In this segment, we explore the depository FIs: Size, structure and composition Balance sheets and recent trends Regulation of depository institutions Depository institutions performance

    Slide 59:Products of FIs Comparing the products of FIs in 1950, to products of FIs in 2003: Much greater distinction between types of FIs in terms of products in 1950 than in 2003 Blurring of product lines and services over time Wider array of services offered by all FI types

    Slide 60:Specialness of Depository FIs Products on both sides of the balance sheet Loans Business and Commercial Deposits

    Slide 61:Other outputs of depository FIs Other products and services 1950: Payment services, Savings products, Fiduciary services By 2003, products and services further expanded to include: Underwriting of debt and equity, Insurance and risk management products

    Slide 62: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

    Slide 63:Largest Depository Institutions in the US Citigroup $1,208.9 J.P. Morgan Chase* 770.9 Bank of America** 736.4 Wells Fargo 393.9 Wachovia 388.0 Bank One* 326.6 Washington Mutual 275.2 Fleet Boston** 200.2 U.S. Bancorp 188.8 SunTrust Banks 181.0

    Slide 64:Organization of Depository Institutions Commercial Banks Largest depository institutions are commercial banks. Differences in operating characteristics and profitability across size classes. Notable differences in ROE and ROA as well as the spread Thrifts S&Ls Savings Banks Credit Unions Mix of very large banks with very small banks

    Slide 65:Functions & Structural Differences 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 Reigle-Neal Act (1994) in the US In Spain, deregulation in 1989 concerning savings banks operations

    Slide 66:Commercial Banks Primary assets: Real Estate Loans: $2,272.3 billion C&I loans: $870.6 billion Loans to individuals: $770.5 billion Investment security portfolio: $1,789.3 billion Of which, Treasury bonds: $1,005.8 billion Inference: Importance of Credit Risk

    Slide 67:Commercial Banks Primary liabilities: Deposits: $5,028.9 billion Borrowings: $1,643.3 billion Other liabilities: $238.2 billion Inference: Highly leveraged

    Slide 68:Small Banks, US

    Slide 69:Large Banks, US

    Slide 70:Structure and Composition Shrinking number of banks: 14,416 commercial banks in 1985 12,744 in 1989 7,769 in 2004 Mostly the result of Mergers and Acquisitions M&A prevented prior to 1980s, 1990s Consolidation has reduced asset share of small banks

    Slide 71:Structure & Composition of Commercial Banks Financial Services Modernization Act 1999 Allowed full authority to enter investment banking (and insurance) Limited powers to underwrite corporate securities have existed only since 1987

    Slide 72:Composition of Commercial Banking Sector Community banks Regional and Super-regional Access to federal funds market to finance their lending activities Money Center banks Bank of New York, Deutsche Bank (Bankers Trust), Citigroup, J.P. Morgan Chase, HSBC Bank USA declining in number

    Slide 73:Balance Sheet and Trends Business loans have declined in importance Offsetting increase in securities and mortgages Increased importance of funding via commercial paper market Securitization of mortgage loans

    Slide 74:Some Terminology Transaction accounts Negotiable Order of Withdrawal (NOW) accounts (“cuenta a la vista”) Money Market Mutual Fund Negotiable CDs (“certificados de depósito”): Fixed-maturity interest bearing deposits with face values over $100,000 that can be resold in the secondary market.

    Slide 75:Off-balance Sheet Activities Heightened importance of off-balance sheet items Large increase in derivatives positions is a major issue Standby letters of credit Loan commitments When-issued securities Loans sold

    Slide 76:Trading and Other Risks Allied Irish / Allfirst Bank $750 million loss (2001) National Australian Bank $450 million loss (2004) Failure of the U.K. investment bank Barings The Bankruptcy of Orange County in California.

    Slide 77:Other Fee-generating Activities Trust services Correspondent banking Check clearing Foreign exchange trading Hedging Participation in large loan and security issuances Payment usually in terms of noninterest bearing deposits

    Slide 78:Key Regulatory Agencies FDIC and the Office of the Comprotroller of the Currency in the US. European Central Bank National central banks National Governments Regional Governments

    Slide 79:Web Resources For more detailed information on the regulators, visit:

    Slide 80:Banking and Ethics Some cases for the US: Bank of America and Fleet Boston Financial 2004 J.P. Morgan Chase and Citigroup 2003 role in Enron Riggs National Bank and money laundering concerns 2003

    Slide 81:Savings Institutions Comprised of: Savings and Loans Associations Savings Banks Effects of moral hazard and regulator forbearance. Quite a debate worldwhile.

    Slide 82:Savings Institutions: Recent Trends Industry is smaller overall Intense competition from other FIs mortgages for example Concern for future viability in certain countries.

    Slide 83:Credit Unions Nonprofit depository institutions owned by member-depositors with a common bond. Exempt from taxes and Community Reinvestment Act (CRA) in the US. Expansion of services offered in order to compete with other FIs. Very important in certain European countries (Germany, Spain).

    Slide 84:Global Issues Near crisis in Japanese Banking Eight biggest banks reported positive six-month profits China Deterioration, NPLs (nonperforming loans) at 50% levels Opening to foreign banks (WTO entry) German bank problems in early 2000s Implications for future competitiveness

    Slide 85:Largest Banks in the World

    Slide 87:Commercial Banks Represent the largest group of depository institutions measured by asset size. Perform functions similar to those of savings institutions and credit unions - they accept deposits (liabilities) and make loans (assets) Liabilities include nondeposit sources of funds such as subordinated notes and debentures Loans are broader in range, including consumer, commercial, international, and real estate

    Slide 88:Differences in Balance Sheets

    Slide 89:Commercial Bank Balance Sheet

    Slide 90:Commercial Bank Balance Statement (liabilities)

    Slide 91:The importance of lending (I) The history of banking institutions is the history of lending itself. Banks solve asymmetric information problems through lending. The relevance of lending is not exclusive of commercial banks. It is even more important at other depository instituions (in relative terms).

    Slide 92:The importance of lending (II) Lending and the resolution of asymmetric information problems are usually studied within an IO perspective. A large amount of contracts is needed to achieve efficiency and to solve asymmetric information problems: relevance of scale and scope economies and efficiency.

    Slide 93:Economies of Scale and Scope Economies of scale - the degree to which a firm’s average unit costs of producing financial services fall as its output of services increase Economies of scope - the degree to which a firm can generate cost synergies by producing multiple financial service products Megamerger - the merger of banks with assets of $1 billion or more X efficiencies - cost savings due to the greater managerial efficiency of the acquiring firm

    Slide 94:Measuring Economies of Scale

    Slide 95:Economies of Scale and the Effect of Technology Improvement

    Slide 96:Economies of Scope By offering more services to a given customer; revenue can be enhanced costs can be reduced Cost economies of scope investments in one financial service (such as lending) may reduce costs to produce financial services in other areas (such as securities underwriting or brokerage) Revenue economies of scope

    Slide 97:Bank Size and Activities Large banks have easier access to capital markets and can operate with lower amounts of equity capital Large banks tend to use more purchased funds (such as fed funds) and have fewer core deposits Large banks lend to larger corporations which means that their interest rate spread is narrower the difference between lending and deposit rates Large banks are more diversified and generate more noninterest income

    Slide 98:Industry Performance Provision for loan losses - bank management’s recognition of expected bad loans for the period Net charge-offs - actual losses on loans and leases Net operating income - income before taxes and extraordinary items

    Slide 99:Thrift Institutions and Savings & Cooperative Banks Savings Associations concentrated primarily on residential mortgages Savings Banks large concentration of residential mortgages commercial loans corporate bonds corporate stock Credit Unions consumer loans funded with member deposits

    Slide 100:IN THE US: Regulator forbearance - a policy of the FSLIC not to close economically insolvent FIs, allowing them to continue in operation IN EUROPE: More variety and diversity. All sorts of savings banks and credit cooperative structures (private, public, semi-public). Mutual organization - an institution in which the liability holders are also the owners: THE CASE OF PROXIMITY BANKING: COMMUNITY BANKS IN THE US SAVINGS BANKS IN EUROPE

    Slide 101:Financial Statements of Commercial Banks Report of condition - balance sheet of a commercial bank reporting information at a single point in time Report of income - income statement of a commercial bank reporting revenues, expenses, net profit or loss, and cash dividends over a period of time Retail bank - one that focuses its business activities on consumer banking relationships Wholesale bank - one that focuses its business activities on commercial banking relationships

    Slide 102:Assets Four major subcategories cash and balances due from other depository institutions vault cash, deposits at the Federal Reserve, deposits at other FIs, and cash items in the process of collection investment securities interest-bearing deposits at other FIs, fed funds sold, RPs, U.S. Treasury and agency securities, securities issued by states and political subdivisions, mortgage-backed securities, and other debt and equity securities loans and leases other assets premises and fixed assets, real estate owned, investments in unconsolidated subsidiaries, intangible assets, other fees receivable

    Slide 103:Liabilities NOW account - negotiable order of withdrawal account, similar to a demand deposit with minimum balance MMDAs - money market deposit accounts with retail savings accounts and limited checking account (IN THE US) Other savings deposits - other than MMDAs (IN EUROPE): basically customer (savings and term) deposits)

    Slide 104:Liabilities Negotiable instrument - an instrument whose ownership can be transferred in the secondary market Purchased funds - rate-sensitive funding sources of the bank (ej. “cesiones temporales de activos”).

    Slide 105:Equity Capital Preferred and common stock (listed at par value) Surplus or additional paid-in capital Retained earnings Regulations require banks to hold a minimum level of equity capital to act as a buffer against losses from their on- and off-balance sheet assets

    Slide 106:Off-Balance-Sheet Assets and Liabilities Contingent assets and liabilities that may affect the future status of the FIs balance sheet OBS activities grouped into 5 major categories Loan commitments - contractual commitment to loan to a firm a certain maximum amount at given interest rate terms up-front fee - fee charged for making funds available through a loan commitment back-end fee - fee charged on the unused component of a loan commitment (continued)

    Slide 107: Loans Sold (securitization) loans that a bank originated and then sold to other investors that may be returned (with recourse) to the originating institution in the future recourse - the ability to put an asset or loan back to the seller should the credit quality of that asset deteriorate Derivative Contracts futures, forward, swap, and option positions taken by the FI for hedging or other purposes

    Slide 108:Income Statement Interest Income Interest Expenses Net Interest Income Provision for Loan Losses Noninterest Income Noninterest Expense Income before Taxes and Extraordinary Items Income Taxes Extraordinary Items Net Income

    Slide 109:The Direct Relationship between the Income Statement and the Balance Sheet

    Slide 110:Financial Statement Analysis Using a Return on Equity Framework

    Slide 111:Return on Assets and Its Components

    Slide 112:Profit Margin

    Slide 113:Asset Utilization

    Slide 114:Net Interest Margin

    Slide 115:Spread

    Slide 116:Overhead Efficiency

    Slide 118:Risks Faced by Financial Intermediaries Credit Risk Liquidity Risk Interest Rate Risk Market Risk Off-Balance-Sheet Risk Foreign Exchange Risk Country or Sovereign Risk Technology Risk Operational Risk Insolvency Risk

    Slide 119:Market Risk Incurred in trading of assets and liabilities (and derivatives). Examples: Barings & decline in ruble. DJIA dropped 12.5 percent in two-week period July, 2002. Heavier focus on trading income over traditional activities increases market exposure. Trading activities introduce other perils as was discovered by Allied Irish Bank’s U.S. subsidiary, AllFirst Bank when a rogue trader successfully masked large trading losses and fraudulent activities involving foreign exchange positions

    Slide 120:Market Risk Distinction between Investment Book and Trading Book of a commercial bank Heightened focus on Value at Risk (VAR) Heightened focus on short term risk measures such as Daily Earnings at Risk (DEAR) Role of securitization in changing liquidity of bank assets and liabilities

    Slide 121:Credit Risk Risk that promised cash flows are not paid in full. Firm specific credit risk Systematic credit risk High rate of charge-offs of credit card debt in the 1980s, most of the 1990s and early 2000s Credit card loans (and unused balances) continue to grow

    Slide 122:Implications of Growing Credit Risk Importance of credit screening Importance of monitoring credit extended Role for dynamic adjustment of credit risk premia Diversification of credit risk

    Slide 123:Off-Balance-Sheet Risk Striking growth of off-balance-sheet activities Letters of credit Loan commitments Derivative positions Speculative activities using off-balance-sheet items create considerable risk

    Slide 124:Technology and Operational Risk Risk that technology investment fails to produce anticipated cost savings. Risk that technology may break down. CitiBank’s ATM network, debit card system and on-line banking out for two days Wells Fargo Bank of New York: Computer system failed to recognize incoming payment messages sent via Fedwire although outgoing payments succeeded

    Slide 125:Technology and Operational Risk Operational risk not exclusively technological Employee fraud and errors Losses magnified since they affect reputation and future potential Merrill Lynch $100 million penalty

    Slide 126:Country or Sovereign Risk Result of exposure to foreign government which may impose restrictions on repayments to foreigners. Often lack usual recourse via court system. Examples: Argentina Russia South Korea

    Slide 127:Country or Sovereign Risk In the event of restrictions, reschedulings, or outright prohibition of repayments, FIs’ remaining bargaining chip is future supply of loans Weak position if currency collapsing or government failing Role of IMF Extends aid to troubled banks Increased moral hazard problem if IMF bailout expected

    Slide 128: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 liquidity problem into solvency problem. Risk of systematic bank panics. Example: 1985, Ohio savings institutions insured by Ohio Deposit Guarantee Fund Interaction of credit risk and liability risk Role of FDIC (see Chapter 19)

    Slide 129:Insolvency Risk Risk of insufficient capital to offset sudden decline in value of assets to liabilities. Continental Illinois National Bank and Trust Original cause may be excessive interest rate, market, credit, off-balance-sheet, technological, FX, sovereign, and liquidity risks.

    Slide 130:Credit Risk Management An FI’s ability to evaluate information and control and monitor borrowers allows them to transform financial claims of household savers efficiently into claims issued to corporations, individuals, and governments An FI accepts credit risk in exchange for a fair return sufficient to cover the cost of funding (e.g., covering the cost of borrowing, or issuing deposits)

    Slide 131:Credit Analysis Real Estate Lending residential mortgage loan applications are among the most standardized of all credit applications Two considerations the applicant’s ability and willingness to make timely interest and principal repayments the value of the borrower’s collateral GDS (gross debt service) ratio - gross debt service ratio calculated as total accommodation expenses (mortgage, lease, condominium, management fees, real estate taxes, etc.) divided by gross income TDS (total debt service) ratio - total debt ratio calculated as total accommodation expenses plus all other debt service payments divided by gross income

    Slide 132:Credit Scoring Credit scoring system a mathematical model that uses observed loan applicant’s characteristics to calculate a score that represents the applicant’s probability of default Perfecting collateral ensuring that collateral used to secure a loan is free and clear to the lender should the borrower default Foreclosure taking possession of the mortgaged property to satisfy a defaulting borrower’s indebtedness Power of sale taking the proceedings of the forced sale of property to satisfy the indebtedness

    Slide 133:Credit Scoring Consumer (individual) and Small-business lending techniques for scoring consumer loans very similar to mortgage loan credit analysis but more emphasis placed on personal characteristics such as annual gross income and the TDS score small-business loans more complicated and has required FIs to build more sophisticated scoring models combining computer-based financial analysis of borrower financial statements with behavioral analysis of the owner

    Slide 134:Ratio Analysis Historical audited financial statements and projections of future needs Calculation of financial ratios in financial statement analysis Relative ratios offer information about how a business is changing over time Particularly informative when they differ either from an industry average or from the applicant’s own past history

    Slide 135:Calculating Ratios

    Slide 139:Common Size Analysis and After the Loan Analyst can divide all income statement amounts by total sales revenue and all balance sheet amounts by total assets Year to year growth rates give useful ratios for identifying trends Loan covenants reduce risk to lender Conditions precedent those conditions specified in the credit agreement or terms sheet for a credit that must be fulfilled before drawings are permitted

    Slide 140:Large Commercial and Industrial Lending Very attractive to FIs because transactions are often large enough make them very profitable even though spreads and fees are small in percentage FIs act as broker, dealer, and adviser in credit management The standard methods of analysis used for mid-market corporates applied to large corporate clients but with additional complications Financial ratios such as the debt-equity ratio are usually key factors for corporate debt

    Slide 141:Altman’s Z-Score

    Slide 142:The KMV Model Banks can use the theory of option pricing to assess the credit risk of a corporate borrower The probability of default is positively related to: the volatility of the firm’s stock the firm’s leverage A model developed by KMV corporation is being widely used by banks for this purpose

    Slide 143:Calculating the Return on a Loan A number of factors impact the promised return that an FI achieves on any given dollar loan the interest rate on the loan any fees relating to the loan the credit risk premium on the loan the collateral backing the loan other nonprice terms (such as compensating balances and reserve requirements)

    Slide 144:Return on Assets (ROA)

    Slide 145:Risk-Adjusted Return on Capital (RAROC) Rather than evaluating the actual or promised annual cash flow on a loan as a percentage of the amount lent (ROA), the lending officer balances the loan’s expected income against the loan’s expected risk RAROC = One-year income on a loan/Loan (asset risk or capital at risk

    Slide 147:Overview The aim is to discuss the existence of different types of loans, and the analysis and measurement of credit risk on individual loans. This is important for purposes of: Pricing loans and bonds Setting limits on credit risk exposure

    Slide 148:Credit Quality Problems Problems with junk bonds, residential and farm mortgage loans. More recently, credit card and auto loans. Crises in Asian countries such as Korea, Indonesia, Thailand, and Malaysia. Default of one major borrower can have significant impact on value and reputation of many FIs Emphasizes importance of managing credit risk

    Slide 149:Credit Quality Problems Over the early to mid 1990s, improvements in NPLs (non-performing loans) for large banks and overall credit quality. Late 1990s concern over growth in low quality auto loans and credit cards, decline in quality of lending standards. Exposure to Enron. Late 1990s and early 2000s: telecom companies, tech companies, Argentina, Brazil, Russia, South Korea New types of credit risk related to loan guarantees and off-balance-sheet activities. Increased emphasis on credit risk evaluation.

    Slide 150:Types of Loans: C&I (commercial and industrial) loans: secured and unsecured Syndication Spot loans, Loan commitments Decline in C&I loans originated by commercial banks and growth in commercial paper market. Downgrades of Ford, General Motors and Tyco RE (real state) loans: primarily mortgages Fixed-rate, variable rates Mortgages can be subject to default risk when loan-to-value declines.

    Slide 151:*CreditMetrics (sistema patentado) “If next year is a bad year, how much will I lose on my loans and loan portfolio?” VAR = P × 1.65 × s Neither P, nor s observed. Calculated using: (i)Data on borrower’s credit rating; (ii) Rating transition matrix; (iii) Recovery rates on defaulted loans; (iv) Yield spreads.

    Slide 152:* Credit Risk+ (sistema patentado) Developed by Credit Suisse Financial Products. Based on insurance literature: Losses reflect frequency of event and severity of loss. Loan default is random. Loan default probabilities are independent. Appropriate for large portfolios of small loans. Modeled by a Poisson distribution.

    Slide 153:Credit risk measurement has evolved dramatically over the last 20 years. The five forces made credit risk measurement become more important than ever before: A worldwide structural increase in the number of bankruptcies. A trend towards disintermediation by the highest quality and largest borrowers.

    Slide 154:(iii) More competitive margins on loans. (iv) A declining value of real assets in many markets. (v) A dramatic growth of off-balance sheet instrument with inherent default risk exposure, including credit risk derivatives.

    Slide 155:Responses of academics and practitioners: Developing new and more sophisticated credit-scoring/early-warning systems Moved away from only analyzing the credit risk of individual loans and securities towards developing measures of credit concentration risk Developing new models to price credit risk (e.g. RAROC) Developing models to measure better the credit risk of off-balance sheet instruments

    Slide 156:Measurement of the Credit risk of Off-balance Sheet Instruments The expansion in off-balance sheet instrument – such as swaps, options, forwards, futures, etc. Default risk of the instruments have been concerned. It has been reflected in the BIS risk-based capital ratio. The models like KMV, OPM can be applied to measure the probability of default on off-balance sheet instruments.

    Slide 157:Measurement of the Credit risk of Off-balance Sheet Instruments (cont.) Differences between the default risk on loans and off-balance sheet instruments: Even if the counter-party is in financial distress, it will only default on out-of-the-money contracts. For any given probability of default, the amount lost on default is usually less for off-balance sheet instruments than for loans.

    Slide 158:Measures of credit concentration risk The measurement of credit concentration risk is also important Early approaches to concentration risk analysis were based either on: Subjective analysis Limiting exposure in an area to a certain percent of capital (e.g. 10%) Migration analysis

    Slide 159:Measures of credit concentration risk (cont.) Modern portfolio theory (MPT) - By taking advantage of its size, an FI can diversify considerable amounts of credit risk as long as the returns on different assets are imperfectly correlated increasingly being applied to loans and other fixed income instruments recently

    Slide 160:Accounting based credit-scoring systems Four methodological approaches to developing multivariate credit-scoring systems: The linear probability model The logit model The probit model The discriminant analysis model

    Slide 161:Other (newer) models of credit risk measurement Three criticisms of accounting based credit-scoring models Accounting data fails to pick up fast-moving changes in borrower conditions The world is inherently non-linear They are only tenuously linked to an underlying theoretical model

    Slide 162:Other (newer) models –KMV model (cont.) Step 2: calculate distance to default (D) D = (A-B)/ sA Step 3: calculate EDF A B EDF (A<B)

    Slide 163:Other (newer) models- Term structure applications Jonkhart(1979), seek to impute implied probabilities of default(1-p) from term structure of yield spreads between default free and risky corporate securities. -the spreads between Treasury strips and zero-coupon corporate bond reflect perceived credit risk exposures

    Slide 164:APPENDIX: Bank regulation and credit risk: an example from Basel II and savings banks Historically, regulation has limited who can: open or charter new banks and what products and services banks can offer. Imposing barriers to entry and restricting the types of activities banks can engage in clearly enhance safety and soundness, but also hinder competition.

    Slide 165:It assumed that the markets for bank products, largely bank loans and deposits, could be protected and that other firms could not encroach upon these markets. Not surprisingly, investment banks, hybrid financial companies, insurance firms, and others found ways to provide the same products as banks across different geographic markets.

    Slide 166:However, there is another type of regulation that has concentrated most of the attention in the last three decades, the bank capital regulation. Changes in reserve requirements …directly affect the amount of legal required reserves and thus change the amount of money a bank can lend out. The main recent example is BASEL II.

    Slide 167:Basel 2 is a ‘step change’ in the regulation of capital adequacy. It will alter the industry ‘frame of reference’ for banks in many ways: Regulators are clearly recognizing market realities and seeking a much closer congruence between regulatory and economic capital. The new proposals are more complex and sophisticated than earlier schemes. They will also have to evolve as market conditions, technology and financial management techniques develop.

    Slide 168:The calibration exercises that have resulted from the various Quantitative Impact Studies (QIS) are targeted (initially at least) to deliver broadly the same amount of capital as the current Accord. However, the mix of capital charges will change significantly with the wider range of risk weights and greater risk sensitivity of Basel 2. Basel 2 will clearly be much more risk-sensitive in assigning capital charges. Mortgage lending and lending to higher quality borrowers will be incentivied under Basel 2.

    Slide 169:It is not clear whether the present or new Basel Accord are a binding constraint on bank’s current credit operations. Jackson et al (2001, Bank of England WP) suggest that banks may employ more conservative capital standards than those imposed under Basel 1 or likely under Basel 2. Compliance costs are likely to increase. Banks will have to evaluate (as a kind of capital investment decision) whether the costs (including compliance costs) of moving to the more advanced Basel 2 systems are worthwhile.

    Slide 170:Banks will increasingly target better risk management as a source of competitive advantage. Increasingly, superior risk management will become a ‘key success factor’ for those banks who are able to respond successfully to the new environment. Nevertheless, specialist banks who focus on a smaller number of core products and services should similarly be able to obtain risk management benefits of specialization.

    Slide 171:Basel 2 will enhance present securitisation trends in banking. This will help in its turn to emphasise further the strategic importance of investment banking. At the same time, lending bankers will face increasing ‘adverse selection’ trends as the better credits are able to access directly the capital markets. This trend will help to re-emphasise the importance of credit skills in lending banks. It will also put pressure on these banks to widen their margins (in order to achieve the higher risk premia needed to cover their more risky lending).

    Slide 172:Governance will be an increasingly important issue in the new regime. More disclosure is not enough by itself to secure market discipline (the aim of Pillar 3). A wide collection of new and improved governance structures will be needed. These include: a freer market in bank corporate control; good corporate governance in banks; incentive-compatible safety nets; ‘no bail-out’ policies; and proper accounting standards. Banks will be required to disclose more information than ever before to the external market. This will involve additional compliance costs. Strategically, it will reinforce any competitive advantage gained by good risk-management banks.

    Slide 173:Under Pillar 3 and with likely changes in bank governance arrangements, the prospects of take-overs (and no bail-outs) for individual banks who are ‘inefficient’ are likely to increase. This ‘new world’ is a likely further threat to concepts like mutuality and subsidised (or at least protected from competition) regional banking. Insofar as the new capital regime allows non-bank financial companies a competitive advantage (via lesser capital backing), banks will attempt to alter the balance of competitive advantage through regulatory arbitrage

    Slide 174:More work is needed on stress testing under Basel 2 and banks can expect further, more detailed efforts from regulators in this area. Already, stress testing appears to be a standard management technique for many banks and most banks that stress test do so at a high frequency (daily or weekly): see Fender and Gibson (Risk, 2001).

    Slide 175: Perhaps the most fundamental strategic impact of Basel 2 is that it will enhance the SWM (Shareholder Wealth Maximisation) model as the major strategic and managerial model for banks. The essence of this model is its focus on risk and return and the impact of this tradeoff on bank value; the model also emphasises the need for greater risk sensitivity in risk assessments and pricing. Within this model, better risk management is rewarded.

    Slide 176:Although most of the strategic implications mentioned earlier for retail banks apply also to Spanish savings banks, there are some specific features of the Spanish savings banks that may modify some of these conclusions. These specific features are explored in this section (and summarised in Diagram 1): There have been some recent regulatory actions regarding risk and capital in the Spanish banking system that should be taken into account when defining the threats and opportunities of the new framework for savings banks. The development of a Default Hedging Statistical Fund (the so-called FECI) by the Bank of Spain are two of the recent developments in the regulatory field that impact on the current solvency risk of Spanish savings banks

    Slide 178:The establishment of so-called statistical, pro-cyclical or dynamic provisions: Requiring banks to increase these provisions when the business cycle is positive and reducing them during downturns in order to favor intertemporal risk smoothing and loan supply. Basel 2 does not appear to change the view of banking as a pro-cyclical business. Basel 2 could even exacerbate cyclical effects. It is this contingency that has led the Bank of Spain to establish the so-called pro-cyclical or dynamic provisions. The recent lending patterns of the Spanish savings banks are known to reduce these pro-cyclical effects since they have increased credit supply almost linearly over the business cycle.

    Slide 179:The lending behavior of savings banks has not resulted in higher defaults. On the contrary, default risk management at savings banks has apparently been more efficient than for commercial banks, a fact that may be largely explained by the intertemporal risk smoothing advantages achieved via a close contractual relationship with their customers.

    Slide 180:There are three main types of “savings-bank” specific effects: (1) those concerning the aim of Basel 2 and the differences between economic and regulatory capital; (2) those that refer to specialisation, size and lending diversification; (3) those related to the implementation of the new capital adequacy requirements, including the sectoral project of Spanish savings banks for the global control of risk.

    Slide 181:(i) Aim of Basel 2 and Economic and Regulatory Capital Differences While the objective of Stakeholder Wealth Maximisation (STWM) may match more closely the nature of Spanish savings banks, SWM should not be a problem for savings institutions since they have to compete with commercial banks. Nevertheless, the SWM model will be reinforced by Basel 2 and Spanish savings banks may benefit from recent regulatory changes that stress their ownership status as private and non-subsidised.

    Slide 182: (ii) Size, specialisation and lending diversification Specialist banks (like savings banks) focusing on a smaller number of core products may also be able to obtain the risk management benefits of specialisation. Continuous calibration and capital treatment may reduce the potential loss of competitiveness in retail banking. Servicing, relationship banking and dynamic lending will also be valued positively.

    Slide 183:(iii) Final implementation of Basel 2 on Spanish savings banks: the sectoral project for the global control of risk The Spanish Confederation of Savings Banks (CECA) has led an ambitious initiative to undertake a sectoral project for the global control of risk. Since this project is oriented to the whole savings bank sector, it has to deal with various problems, like the rigidities of employing a single model for all institutions. However, the project is targetted to provide savings banks with adequate and centralised human and technological resources in order to implement their own model with a high standard of quality.

    Slide 184: The model for each line of business incorporates risk measurement, control and management operating with three different working groups: information management; organization and procedures; quantitative tools.

    Slide 185:COMPARATIVE DESCRIPTIVE STATISTICS The credit risk of Spanish depository institutions does not seem to be a concern in the short-run. The ratios “doubtful assets/total exposures” and “doubtful loans of other resident sectors/total exposures of resident sectors” have decreased in recent years and are lower than 1% (Table 1). “Statistical” provisions have increased over time as a percentage of total provisions (Table 1).

    Slide 187: Savings banks and credit co-operatives have enjoyed higher margins compared to commercial banks (Table 2). The margins are in line with the European standards. However, competitive presures have resulted in a decrease of margins over time during the last years.

    Slide 189:As shown in Table 3, Spanish banks have progressively changed their financial structure to fulfill the requirements of Basel 2. Both Tier 1 and Tier 2 capital have increased significantly in recent years. Banks have increased both the average weight of credit risk exposure and off-balance sheet exposure.

    Slide 191:Changes in capitalization structure have led to an anticipated fulfillment of Basel 2 requirements (Figure 1a). Tier 1 capital has largely contributed to a reduction in capital requirements, in a context of a significant increase in risk-weighted assets (rise in overall business and Santander’s purchase of Abbey National) (Figure 1b). However, Tier 1 capital has contributed to the growth rate of capital (Figure 1c). Reserves have contributed largely to the growth of Tier 1 capital while the contribution of intangible assets has been negative (Figure 1d).

    Slide 195:Interest Rate Risk Measurement Repricing or funding gap GAP: the difference between those assets whose interest rates will be repriced or changed over some future period (RSAs) and liabilities whose interest rates will be repriced or changed over some future period (RSLs) Rate Sensitivity the time to reprice an asset or liability a measure of an FI’s exposure to interest rate changes in each maturity “bucket” GAP can be computed for each of an FI’s maturity buckets

    Slide 196:Calculating GAP for a Maturity Bucket

    Slide 197:Simple Bank Balance Sheet and Repricing Gap

    Slide 198:Weakness in the Repricing Model Four major weaknesses it ignores market value effects of interest rate changes it ignores cash flow patterns within a maturity bucket it fails to deal with the problem of rate-insensitive asset and liability cash flow runoffs and prepayments it ignores cash flows from off-balance-sheet activities

    Slide 199:Duration Model

    Slide 200:Insolvency Risk Management Net worth a measure of an FI’s capital that is equal to the difference between the market value o its assets and the market value of its liabilities Book Value value of assets and liabilities based on their historical costs Market value or mark-to-market value basis balance sheet values that reflect current rather than historical prices

    Slide 201:Effects of Changes in Loan Values and Interest Rates on the Balance Sheet

    Slide 202:The Book Value of Shares The book value of capital usually comprises three components in banking Par value of shares - the face value of the common shares issued by the FI time the number of shares outstanding Surplus value of shares - the difference between the price the public paid for common shares and their par values Retained earnings - the accumulated value of past profits not yet paid in dividends to shareholders Book value of its capital = Par value + Surplus + Retained earnings

    Slide 203:The Discrepancy between the Market and Book Values of Equity The degree to which the book value of an FI’s capital deviates from its true economic market value depends on a number of values Interest Rate Volatility - the higher the interest rate, the greater the discrepancy Examination and Enforcement - the more frequent the examinations and the stiffer the examiner’s standards, the smaller the discrepancy Loan Trading - the more loans traded the easier to assess the true market value of the loan portfolio

    Slide 204:Calculating Discrepancy Between Book Values (BV) and Market Values (MV)

    Slide 205:Central Bank & Interest Rate Risk Federal Reserve Bank: U.S. central bank Open market operations influence money supply, inflation, and interest rates Oct-1979 to Oct-1982, nonborrowed reserves target regime – did not work Implications of reserves target policy: Increases importance of measuring and managing interest rate risk. Effects of interest rate targeting. Lessens interest rate risk Greenspan view: Risk Management Focus on Federal Funds Rate Simple announcement of Fed Funds increase, decrease, or no change.

    Slide 206:Repricing Model Repricing or funding gap model based on book value. Contrasts with market value-based maturity and duration models recommended by the Bank for International Settlements (BIS). Rate sensitivity means time to repricing. Repricing gap is the difference between the rate sensitivity of each asset and the rate sensitivity of each liability: RSA - RSL. Refinancing risk

    Slide 207:Maturity Buckets Commercial banks must report repricing gaps for assets and liabilities with maturities of: One day. More than one day to three months. More than 3 three months to six months. More than six months to twelve months. More than one year to five years. Over five years.

    Slide 208:Repricing Gap Example Assets Liabilities Gap Cum. 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

    Slide 209:Repricing Gap

    Slide 210:Applying the Repricing Model DNIIi = (GAPi) DRi = (RSAi - RSLi) Dri Example: In the one day bucket, gap is -$10 million. If rates rise by 1%, DNII(1) = (-$10 million) × .01 = -$100,000.

    Slide 211:Restructuring Assets & Liabilities The FI can restructure its assets and liabilities, on or off the balance sheet, to benefit from projected interest rate changes. Positive gap: increase in rates increases NII Negative gap: decrease in rates increases NII Example: State Street Boston Good luck? Or Good Management?

    Slide 212:Repricing Model Problems with model: measures only short-term profit changes not shareholder wealth changes maturity buckets are arbitrarily chosen assets and liabilities within a bucket are considered equally rate sensitive ignores runoffs ignores prepayments

    Slide 213: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 price. The longer the maturity, the greater the effect of interest rate changes on market price. Fall in value of longer-term securities increases at diminishing rate for given increase in interest rates.

    Slide 214:Maturity Model Leverage also affects ability to eliminate interest rate risk using maturity model Example: Assets: $100 million in one-year 10-percent bonds, funded with $90 million in one-year 10-percent deposits (and equity) Maturity gap is zero but exposure to interest rate risk is not zero.

    Slide 215:Duration Duration Weighted average time to maturity using the relative present values of the cash flows as weights. Combines the effects of differences in coupon rates and differences in maturity. Based on elasticity of bond price with respect to interest rate.

    Slide 216:Duration and Duration Gap market-value based model for managing interest rate risk more accurate measures of interest rate risk exposure than simple maturity model duration gap considers market values and maturity distributions of assets and liabilities unlike repricing model duration measures average life of asset or liability has economic meaning of interest sensitivity of that asset’s or liability’s value

    Slide 217:Duration Duration D = Snt=1[CFt• t/(1+R)t]/ Snt=1 [CFt/(1+R)t] Where D = duration t = number of periods in the future CFt = cash flow to be delivered in t periods n= term-to-maturity R = yield to maturity.

    Slide 218:Duration Gap duration of asset portfolio or liability portfolio is just weighted-average duration of each individual asset or liability also the accounting identity holds A = L + E or ?E = ?A - ?L when rates change, the change in the equity or net worth is equal to the difference between the change in the MV of the assets and liabilities instead of how we used maturity model, here we want to relate sensitivity of net worth to its duration mismatch instead of its maturity mismatch because duration is a more accurate measure of interest rate sensitivity

    Slide 219:Duration Gap assuming similar rate changes for assets and liabilities

    Slide 221:Trading Risks Trading exposes banks to risks 1995 Barings Bank 1996 Sumitomo Corp. lost $2.6 billion in commodity futures trading 1997 market volatility in Eastern Europe and Asia 1998 continuation with Russian bonds AllFirst/ Allied Irish $691 million loss Partly preventable with software Rusnak currently serving 7 ½ year sentence for fraud Allfirst sold to Buffalo based M&T Bank

    Slide 222:Implications Emphasizes importance of: Measurement of exposure Control mechanisms for direct market risk—and employee created risks Hedging mechanisms

    Slide 223:Market Risk Market risk is the uncertainty resulting from changes in market prices . Affected by other risks such as interest rate risk and FX (foreign exchange) risk It can be measured over periods as short as one day. Usually measured in terms of dollar exposure amount or as a relative amount against some benchmark.

    Slide 224:Market Risk Measurement Important in terms of: Management information Setting limits Resource allocation (risk/return tradeoff) Performance evaluation Regulation BIS and Fed regulate market risk via capital requirements leading to potential for overpricing of risks Allowances for use of internal models to calculate capital requirements

    Slide 225:Calculating Market Risk Exposure Generally concerned with estimated potential loss under adverse circumstances. Three major approaches of measurement JPM RiskMetrics (or variance/covariance approach) Historic or Back Simulation Monte Carlo Simulation

    Slide 226:JP Morgan RiskMetrics Model Idea is to determine the daily earnings at risk = dollar value of position × price sensitivity × potential adverse move in yield or, DEAR = Dollar market value of position × Price volatility. Can be stated as (-MD) × adverse daily yield move where, MD = D/(1+R) Modified duration = MacAulay duration/(1+R)

    Slide 227:Confidence Intervals If we assume that changes in the yield are normally distributed, we can construct confidence intervals around the projected DEAR. (Other distributions can be accommodated but normal is generally sufficient). Assuming normality, 90% of the time the disturbance will be within 1.65 standard deviations of the mean.

    Slide 228:Historic or Back Simulation Advantages: Simplicity Does not require normal distribution of returns (which is a critical assumption for RiskMetrics) Does not need correlations or standard deviations of individual asset returns.

    Slide 229:Historic or Back Simulation Basic idea: Revalue portfolio based on actual prices (returns) on the assets that existed yesterday, the day before, etc. (usually previous 500 days). Then calculate 5% worst-case (25th lowest value of 500 days) outcomes. Only 5% of the outcomes were lower.

    Slide 230:Estimation of VAR: Example Convert today’s FX positions into dollar equivalents at today’s FX rates. Measure sensitivity of each position Calculate its delta. Measure risk Actual percentage changes in FX rates for each of past 500 days. Rank days by risk from worst to best.

    Slide 231:Weaknesses Disadvantage: 500 observations is not very many from statistical standpoint. Increasing number of observations by going back further in time is not desirable. Could weight recent observations more heavily and go further back.

    Slide 232:Monte Carlo Simulation To overcome problem of limited number of observations, synthesize additional observations. Perhaps 10,000 real and synthetic observations. Employ historic covariance matrix and random number generator to synthesize observations. Objective is to replicate the distribution of observed outcomes with synthetic data.

    Slide 233:Regulatory Models BIS (including Federal Reserve) approach: Market risk may be calculated using standard BIS model. Specific risk charge. General market risk charge. Offsets. Subject to regulatory permission, large banks may be allowed to use their internal models as the basis for determining capital requirements.

    Slide 234:BIS Model Specific risk charge: Risk weights × absolute dollar values of long and short positions General market risk charge: reflect modified durations ? expected interest rate shocks for each maturity Vertical offsets: Adjust for basis risk Horizontal offsets within/between time zones

    Slide 236:Causes of Liquidity Risk Two types of liquidity risk: when depositors or insurance policyholders seek to cash in or withdraw their financial claims when OBS commitments are exercised Fire-sale price the price received for an asset that has to be liquidated (sold) immediately

    Slide 237:Liability Side Liquidity Risk Core deposits deposits that provide a relatively stable, long-term funding source to a bank Net deposit drains the amount by which cash withdrawals exceed additions; a net cash outflow can be managed two ways: purchased liquidity management stored liquidity management

    Slide 238:Liability Side Liquidity Risk Purchased liquidity federal funds market repurchased (repo) agreement market issue additional fixed-maturity CD’s, notes, and/or bonds Stored liquidity can use or sell off some of it’s assets (such as T-bills) utilize its stored liquidity (i.e., cash in vault)

    Slide 239:Measuring a Bank’s Liquidity Exposure Net liquidity statement measures liquidity position by listing sources and uses of liquidity Peer group ratio comparisons a comparison of its key ratios and balance sheet features with those for banks of a similar size and geographic location Liquidity index measures the potential losses an FI could suffer from a sudden or fire-sale disposal of assets compared to the amount it would receive at a fair market value established under normal market conditions

    Slide 240:Calculation of the Liquidity Index

    Slide 241:Financing Gap and the Financing Requirement Financing gap the difference between a bank’s average loans and average (core) deposits if the financing gap is positive, the bank must fund it by using its cash and liquid assets and/or borrowing funds in the money market Financing requirement the financing gap plus a bank’s liquid assets the larger a bank’s financing gap and liquid asset holdings, the higher the amount of funds it needs to borrow on the money markets and the greater is its exposure to liquidity problems

    Slide 242:Liquidity Planning Allows managers to make important borrowing priority decisions Components of a liquidity plan delineation of managerial details and responsibilities detailed list of fund providers most likely to withdraw and the pattern of fund withdrawals identification of the size of potential deposit and fund withdrawals over various time horizons in the future sets internal limits on separate subsidiaries and branches borrowing and bounds for acceptable risk premiums to pay details a sequencing of assets for disposal

    Slide 243:Deposit Drains and Bank Run Liquidity Risk Deposit drains may occur for a variety of reasons concerns about a bank’s solvency failure of a related bank sudden changes in investor preferences Bank run a sudden and unexpected increase in deposit withdrawals from a bank Bank panic a systemic or contagious run on the deposits of the banking industry as a whole

    Slide 244:Deposit Insurance and Discount Window Deposits insured for $100,000 Federal Reserve provides a discount window facility to meet banks’ short-term nonpermanent liquidity needs loans made by discounting short-term high-quality securities such as T-bills and banker’s acceptances with central bank leads to increased monitoring from the Federal Reserve which acts as a disincentive for banks to use for ‘cheap’ funding

    Slide 245:Liquidity Risk and Insurance Companies Early cancellation of a life insurance policy results in the insurer having to pay the surrender value the amount that an insurance policyholder receives when cashing in a policy early when premium income is insufficient to meet surrenders, the insurer can sell liquid assets such as government bonds Property-Casualty PC insurers have greater need for liquidity due to uncertainty so ten to hold shorter term assets Guarantee Programs for Life and PC Insurance Co.

    Slide 246:Liquidity Risk and Mutual Funds Open-end mutual funds must stand ready to buy back issued shares from investors at their current market price or net asset value If a mutual fund is closed and liquidated, the assets would be distributed on a pro rata basis