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92 Cards in this Set
- Front
- Back
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Give some characteristics of U.S. banks.
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- Financial assets, not real
- Highly regulated - very low equity (6%) - low cost of funds (T-bill 2.5%) - Financial power (bankers on BoD) and political power - Information producers; get inside info no one else gets - crucial to the economy's success (U.S. runs on credit) |
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What is a bank?
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FDIC defines a bank as " any National, State, and District bank, and any Federal branch and insured bank.
- The Federal reserve defines it as a financial institution that is owned by stockholders, operates for a profit, and engages in lending activities. |
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Are the following banks under the Federal Reserve definition? Why?
- S&Ls - Securities companies & Insurance companies - Credit Unions |
S&Ls ARE banks
Sec. Co's and Ins. Co's are NOT banks (they dont make loans) Credit Unions are NOT banks (they are not for profit) |
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Name and define the different types of banks.
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- Global, international or money center banks (TBTFs)
- Medium and Large sice banks that are full-service (but not universal) - Small and Medium size banks that are retail or consumer banks. a.k.a. "Community Banks" -Specialized banks such as banks that focus on Medium and Large size businesses -Limited purpose banks - credit cards |
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What are the two main things banks do for their customers?
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-Payments
-Financial intermediation |
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Describe the "payment" service banks have.
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- coin and currency financial transactions (checking accounts, credit cards, electronic banking, international payments
- Retail payments system and large-dollar payments system for business and government |
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Describe the "financial intermediation" service banks have.
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-Deposit function for savers
-Loan function for borrowers - Other financial services include off-balance sheet risk taking, insurance, securities, and trust services |
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What is disintermediation?
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when banks hold money
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Allocational efficiency/inefficiency
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Eff. - increas standard of living (good jobs, etc)
Ineff. - if banks are gov't owned |
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Operational efficiency/inefficiency
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Eff - low cost to use services (free checking)
Ineff - not taking mastercard bc too high fees |
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Market efficiency/inefficiency
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eff - access to all available information
ineff - mispricing of home loans |
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Name some risks banks take on a daily basis and define them. (remember SCCRFLIP!)
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- credit risk - risk that an obligor may fail to meet the terms of any contract with the bank
- Interest rate risk - cost of funds - Liquidity risk - need cash to loan to customers - price risk - assets increase or decrease in price - F.Ex risk - international foreign exchange - Compliance risk - follow regs or there will be penalties - Strategic risk - competition because of deregulation - Reputation risk - public confidence |
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How do banks compare to other financial service organizations (in market size).
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Banks are the dominanct financial institutions in the U.S. baser on the percentage of total assets (24%)
- Federally regulated mortgage pools have 12%, Life insurance co's have 11% |
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What factors have affected the operations of commercial banks and other financial organizations?
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- Inflation and volatile interest rates
- Securitization - Technological Advances - Consumers are more sophisticated - Capital markets have increased their competition with banks in attracting frims seeking debt funds. - Deregulation - Despecialization (one stop shops) - Global integration of financial markets ins increasing competition from foreign financial service firms. |
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What are the principle sources and uses of bank funds?
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Assets: Loans, Investments, Cash, some ppe
Liabilities: Deposits (including transaction and non-transaction deposits), nondeposit sources Equity: relatively SMALL, very highly leveraged |
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Why are banks regulated?
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Banks are regulated mainly to prevent disruption to the economy.
- Prudential regulation to ensure safety and soundness (prevent large scale failures, reduce contageous systemic risk) - Guard against deposit insurance losses (stops bank runs - now 250K) -Achieve desired social goals (50% loans under median income) |
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Why do banks fail?
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- The number one reason banks fail is credit risk.: The small capital base of banks makees them sensitive to negaite earnings. Banks use loan loss reserves to absorb expected losses on loans and from toher sources. However, unexpected losses must be charged against equity capital and can cause the bank to become insolvent and/or closed by regulators.
- The second biggest reason banks fail is because of fraud.: Fraud includes theft as well as lending to customers favored by friendship or political intereset rather than economic profit for he bank. - Other reasons include financial repression and bank runs. |
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What did the Banking Act of 1933 do?
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- separated ban king from investment banking
- established the FDIC - permitted the Federal Reserve to regulate time deposits and prohibited interest on demand deposits (regulation Q) - Increased the minimum capital requirments onnational banks |
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What did the Banking act of 1935 do?
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- Federal reserve was given an expanded reserve requirement, discount rate, and deposit rate powers.
- Office of the Comptroller of the Currency (OCC) was given expanded powers over granting new national bank charters. New applicants for banks must show that it would be successful and not damage other banks. |
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What does Regulation Q do?
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it limits banks deposit costs - aka a maximum deposit rate. This makes banks more competitive and innovative. Banks saw depost outflows to money market mutual funds in periods of inflation and high interest rates.
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Were there geographic restrictions on interestate banking?
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Yes. This created highly concentrated loan portfolios and made it difficult to service customer needs of large firms with operations throughout the country. Large firms seeking debt finance increasingly used the securities markets to raise funds and not banks.
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What was DIDMCA of 1980 and what did it stipulate?
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Depository Insitutions Deregulation and Monetary Control Act of 1980
- Uniform reserve requirements for all depository institutions. - Federal Reserve services available to all depositry institutions. - Regulation Q was to be phased out by the depository Institutions Deregulation Committee. - Deposit insurance raised to 100K. - Negotiable order of Withdrawal Accounts (interest-bearing checking accounts. - Savings and Loans allowed to make more consumer loans and wer given trust powers. |
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What were the three important steps of progressive deregulation of banking since 1980.
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1 - Reg Q killed
2 - geographic boundaries eliminated 3 - let banks go into security business |
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What did the Garn-St Germain Depository Institutions Act of 1982 do?
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- created MMDAs (with no interest rate cilings and limited check writing privileges) to compete with MMMFs
- FDIC assistance for troubled or failing snstitutions - Net Worth Certificates - used by regulators to keep failing thrifts from being closed (then they became "zombies") - Asset powers of thrifts ezpanded in consumer and commercial lending to enable them to compete with banks. These powers increased risk taking activites of thrifts beyond their traditional home lending activities. They made really risky loans to make up for increased interest rates. |
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What is FIRREA of 1989 and what were its stipulations?
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Regulatory Structure: Federal Home Loan Bank Board Closed and the Office of Thrift Services was established under the U.S. Treasury.
- Federal Savings and Loan Insurance Corporation (FSLIC) closed and was replaced with the Savings Associations and Insurance Funds under the FDIC to insure thrift's deposits. The Bank Insurance Fund was also created under the FDIC to insure banks' deposits. - Thrifts asset powers were reduced by focusing more on home lending. - "Cease and Desist" powers were given to regulators. - Cross-bank guarantees in multi-bank holding companies. |
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What is the FDICIA of 1991 and what were its stipulations?
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The FDICIA stands for Federal Deposit Insurance Corporation Improvement Act of 1991.
- This act called for "Prompt Corrective Action" by regulators, which allowed them to increasingly restrict the activites of undercapitalized institutions. If a bank fell below 6% total risk-adjusted capital, it would get this 'prompt corrective action' - This act also imposed restrictions to protect uninsured depositors in a large bank failure (this lessened the TBTF problem) - Raised deposit insurance fees to build up federal insurance reserves. |
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What was the Riegle-Neal Interstate Banking and Branching Act and what did it do?
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The act allowe interstate banking through multibank holding companies. It also allowed interstate branching.
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What was the Gramm-Leach-Biley Act (aka Financial Services Modernization Act) and what did it do?
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- Allowed banks, brokerage firms, and insurance companies to merge.
- Said that financial holding companies were allowed to engage in a wide variety of financial services. - This did provide that banking and commerce still remain separate. |
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Describe Germany's banking situation.
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"universal banking" with no holding company structure required to offer multiple financial services - can use the bank itself and subsidiaries of the bank. Banks can own commercial firms! (U.S. thinks this can be too much power)
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Describe the U.K.'s banking situation.
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"Clearing banks" engage in commercial and investment banking. Subs can conduct merchant banking, insurance, and real-estate activities.
- The bank of England must approve a firm taking more than 15% interest in a UK bank. Banking and commerce not formally separated. |
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Describe the banking situation in Japan.
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Japan's banking system is similar to the U.S.
- There are 7 MegaFinancial holding companies. These banks are each a 'keiretsu' (conglomerate firm - usually run by families). They are very powerful in close relationships with client firms. |
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Describe the EEC.
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The European Economic Community allows commerial and investment banks, but not insurance activities in the banks. Commerce and banking are allowed, but insurance activities are NOT.
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Describe the banking anc commercie activities in other countries.
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- International banking regulators seek harmonization of prudential standards. Basle Committee on Banking Supervision implemented risk-based capital standards for credit risk in 1988 for banks, and new rules for bank capital beginning in 2007.
- European Union’s Second Banking Directive has sought to introduce uniform banking and financial services rules in the EU. EU’s Own Funds Directive and Solvency Ratio Directive are consistent with the Basle Committee. - International Monetary Fund (IMF) has played a role in regulation in banking crises in countries around the world. |
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Bank Charter type; BHC's; and overlapping regulation
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- OCC charters national banks (N.A. or national association) -- about 2,500 of 7,700 banks in 2004.
- States can issue state charters for banks. - Dual national and state banking system. - Bank holding companies are corporations that hold stock in one of more banks and other financial service firms. The Federal Reserve provides a list of allowable nonbanking activities that are closely related to banking. - Overlapping regulatory authorities of Federal Reserve, OCC, FDIC, OTS, and state banks. Securities Exchange Commission (SEC) also involved in securities regulation of banking organizations. - Regulators charter, regulate (set rules), supervise (influence safety and soundness), and examine (CAMELS and compliance with regulations) banking organizations. - Regulatory dialectic (Kane) between regulators to control bank risk taking and banks to circumvent regulations for profit. |
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What does EMU stand for? What about EC? Describe banking stipulations concerning these groups.
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European Monetary Union - use the Euro
European Community - no country can stop another country's bank from coming into theirs. |
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When creating a framework for evaluating banks' performances, what three criteria should one look at?
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Internal Performance
External Performance Presentation of Bank Financial Statements |
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What should one look at when evaluating a banks internal performance?
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- Bank planning (budget, goals, etc)
- Technology (what the bank needs to operate) - Personnel development (personal selling and geographic expansion |
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What should one look at when evaluating a bank's external performance?
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- Market share (earnings effects, role of technology)
- Regulatory compliance (capital compliance is most important, also lending, securities and other compliance) - Pubic confidence (deposit insurance, public image) |
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What should one look at when evaluating a bank's financial statements?
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-Balance sheet
-Income statement - Interest Income - Noninterest income - Interest expenses - Noninterest expenses - Net profit |
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Name and describe three types of non-deposit funds.
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Fed Funds - bank to bank lending
Repos - big companies to banks Bankers Acceptances - due to international trade |
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Disaggregate ROE in TWO WAYS
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=Net income after taxes / total equity
=ROA x TA/TE (TA/TE is aka "equity multiplier") usually have to use book value because only about 600 banks in the U.S. are traded on exchanges. |
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Disaggregate ROA
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= NI(after taxes)/TA
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Disaggregate NIM
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Net Interest Margin = (Total interest income - Total interest expense)/Total Assets
Note that municipal bond interest may not be taxable, such that it may be grossed up to a pre-tax equivalent basis by dividing minus interest earned by the factor (1-tax rate of bank). |
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"Unravel" ROE
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ROE = NI/OR x OR/TA x TA/TE
NI/OR = Profit margin OR/TA = Asset utilization TA/TE = Equity Multiplier |
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Leverage Ratio
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Total Equity / Total Assets
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Total capital ratio
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(Total Equity + Long-Term debt + Reserve for loan losses) / Total Assets
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Provision for Loan Loss ratio
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= PLL/TL
= Provision for loan losses / total loans and leases |
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Loan ratio
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= Net charge-offs on loans(gross charge-offs minus recoveries or 'workouts') / Total loans and leases
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Reserve ratio
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= reserve for loan losses (reserve for loan losses last year minus gross charge-offs plus PLL and recoveries)/Total loans and losses
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Nonperforming ratio
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Nonperforming assets (nonaccrual loans and restructured loans)/ Total loans and losses
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Name and Describe the C's of Credit in order
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1 - Capacity (of cash flow) - stress test. see how they did during a recession or downturn in their business.
2 - Collateral - to back up losses 3 - Character - want to pay you back; work-out plans |
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Name and describe the three steps of nonperformance
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1 - Delinquent - missed payment
2 - Non-accruing - when it is transferred to lawyers 3 - Charge-off - loan is written off as uncollectable (affects credit) |
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Operating efficiency ratios
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wages and salaries/total expenses
fixed occupancy expenses/ total expenses |
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Temporary investments ratio
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(Fed funds sold, ST securities, cash, trading account securities)/Total Assets
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Volatile Liability Dependency Ratio
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(Total volatile liabilities - Temporary investments) / Net loans and leases
Note: This ratio gives an indication of the extent to which "hot" money is being used to fund the riskiest assets of the bank. |
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Tax ratio
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tax rate = taxes paid/NIBT
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Look over RAROC in notes
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look at RAROC!
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EVA
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Economic Value Added
= adjusted earnings - opportunity cost of capital = NIAT - profit requested by SHs |
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Compare RAROC and EVA
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- Both methods are beneficial in assessing managerial performance and developing incentive compensation schemes compatible with shareholder wealth goals.
- RAROC has short-run perspective (i.e. business unit profit is compared to the unit's capital at risk) - EVA has a long-run perspective (i.e., business unit profit is compared to the cost of capital of the bank) |
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What is the formula for determining the value of the equity of a commercial bank?
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Rate of return = [Dt + (Pt - Pt-1)/ Pt-1], where D is for dividends and P is for stock price. The value (Pt - Pt-1) is the capital gain on the stock.
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What tends to dominate dividends in determining market rates of returns for most bank stocks?
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price changes
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What are the key determinants of stock price?
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The amount of cash flows
The timing of cash flows The riskiness of cash flows |
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What is the present value formula for a stock?
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Vo = CF1 + CF2 + CF3 + … + CFn
===> (1 + r)l (1 + r)2 (1 + r)3 (1 + r)n |
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What are the determinants of changes in stock value?
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Investor expectations changes concerning dividends in the future
Bank risk and market interest rate changes that affect the discount rate |
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When you incorporate the growth rate of earnings, what is the formula for valuing a firm?
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V0 = Div0/(r - g), where g is the nominal growth rate of earnings over time.
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Give info on "looking" at the PE ratio
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Top number is forward looking and based on future expected growth and earnings.
Bottom number is backward looking based on historical data. Merger and acquisition wave has affected P/E ratios. |
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What is a merger? Is it violent?
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target bank is absorbed into the buyer bank and converted to a branch office (loss of bank charter, CEO, and board of directors). Usually very violent.
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What is an acquisition? Is it violent?
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Target bank is incorporated into the bank holding company of the buyer bank as a separate bank. Not as violent as a merger.
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What act in 1994 deregulating interstate banking and stimulated the consolidation wave in the banking industry?
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1994 Riegle-Neal Act
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Are big bank consolidations usually acquisitions or mergers?
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Acquisitions
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What did the Barth, Beaver, and Wolfson study find?
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Barth, Beaver, and Wolfson study found that bank stock prices were positively related to operating earnings and negatively related to securities gains and losses. Apparently, the market views securities gains and losses as an attempt by bank management to smooth earnings (which does not “fool the market”).
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What did the Visser and Wu study find?
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DIDMCA of 1980 changed the determinants of P/E ratios for banks.
Growth was less important after the Act. Dividend payout ratios became more important after the Act. |
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What did the Hughes, Lang, Mester, and Moon study find?
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Interstate banking under the Riegle-Neal Act of 1994
Interstate mergers increased financial gains and lowered operating risk more than within-state mergers of banks. |
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What did the Cybo-Ottone and Murgia study find?
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Mergers between European banks and insurance companies resulted in increases in total stock value, but not between banks and securities firms.
Mergers among financial service firms with a European country increased stock values, but not across national borders. |
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What did the Hawawini and Swary study find?
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Price of target banks increases on average about 11.5% during the week of a M&A announcement. Cash transactions were more profitable for targets than stock deals.
Bidding bank stock values dropped by 1% to 2%. Why buy other banks if your stock price falls? Managerial agency costs (maximize their welfare at expense of shareholders). Roll’s hubris hypothesis due to excessive arrogance on part of bidder management that believes they can do a better job managing the target. Synergy may cause the combined bank to be greater than the sum of its parts (due to cost efficiency or management expertise). |
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What did the Cornett and Tehranian study find?
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-- In the long run banks involved in acquisitions showed higher than
normal cash flow performance and greater asset growth. Thus, in the long run both targets and bidders benefited from an acquisition. |
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What did the Focarelli, Panetta, and Salleo study find?
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-- In the long-run for Italian bank mergers the ROA did not decrease three or more years later and the return on equity increased by 6 percent.
-- For acquisitions both return on assets and return on equity increased about 21 percent and 13 percent, respectively, over the long run for the combined bank buyer and target. |
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The bank MEGAmerger wave: FLIP AND READ.
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Motives:
Agency, hubris, and synergy as before but also diversification and market power. Siems study: No evidence to support diversification and market power motives, as most gains to shareholders from agency, hubris, and synergy motives. Milbourn, Boot, and Thakor study: Assuming that gains in megamergers are not large, the sudden increase in these very large M&As in recent years suggests that: CEOs are seeking to increase their salaries (agency cost motive) Uncertainty in the competitive environment in banking is motivating expansion and diversification to reduce risk. |
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The bank MEGAmerger wave: FLIP AND READ.
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International banking expansion:
For example, the Industrial Bank of Japan, Dai-ichi Kangyo Bank, and Fuji Bank merger in 1999 created the largest bank in the world, Mizuho, with over one trillion dollars in assets. The inter-continental acquisition by Deutsche Bank in Germany of Bankers Trust in the U.S. . Megamergers among banks in Europe. Too big to fail (TBTF) problem increasing in importance. Moral hazard risk increasing due to increasing size of large banks. Are they TBTFs? The FDIC Improvement Act of 1991 says that large banks will not be rescued unless the Treasury Department, in agreement with the President, FDIC, and the Federal Reserve Board, believe that the failure would cause systemic risk via damage to the economy. |
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Concerning asset and liability management, what are two things one should be most concerned about?
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How changes in interest rates affect 1. NIM (short run) and 2. Equity (long run)
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Asset Liability Management Slide
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In general, a short-run management tool:
Construct a sources and uses of funds statement. NIMs are controlled by this management: Example: $100 million 5-year fixed-rate loans at 8% = $8 million interest $90 million 30-day time deposits at 4% = $3.6 million interest $10 million equity Net interest income = $4.4 million Net interest margin (NIM) = ($8 - $3.6)/$100 = 4.4% If interest rates rise 2%, deposit costs will rise in next year but not loan interest. Now, NIM = ($8 - $5.4)/$100 = 2.6%. Thus, NIM depends on interest rates, the dollar amount of funds, and the earning mix (rate x dollar amount). |
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A historical perspective
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Under Reg Q, fixed deposit costs were mainly “core” deposits. Banks created branch offices to attract deposit funds.
Before Oct. 1979, Fed monetary policy kept interest rates stable. Due to the above factors, banks concentrated on asset management. As loan demand increased in the 1960s during bouts of inflation associated with the Vietnam War, banks started to use liability management. Under liability management, banks purchase funds from the financial markets when needed. Unlike core deposits that are not interest sensitive, purchased funds are highly interest elastic. Purchased funds have availability risk -- that is, these funds can dry up quickly if the market perceives problems of bank safety and soundness (e.g., Continental Illinios in 1984). |
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Measuring Interest rate sensitivity and the Dollar Gap
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Dollar gap:
RSA($) - RSL($) (or dollars of rate-sensitive assets minus dollars of rate-sensitive liabilities, which normally are less than one-year maturity). To compare 2 or more banks, or make track a bank over time, use the: Relative gap ratio = Gap$/Total Assets or Interest rate sensitivity ratio = RSA$/$RSL$. Positive dollar gap occurs when RSA$>RSL$. If interest rates rise (fall), bank NIMs or profit will rise (fall). The reverse happens in the case of a negative dollar gap where RSA$<RSL$. A zero dollar gap would protect bank profits from changes in interest rates. |
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Measuring Interest rate sensitivity and the Dollar Gap
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Dollar Gap:
Interest rate forecasts can be important in earning bank profit. If interest rates are expected to increase in the near future, the bank could use a positive dollar gap as an aggressive approach to gap management. If interest rates are expected to decrease in the near future, the bank could use a negative dollar gap (so as rate declined, bank deposit costs would fall more than bank revenues, causing profit to rise). Incremental and cumulative gaps Incremental gaps measure the gaps for different maturity buckets (e.g., 0-30 days, 30-90 days, 90-180 days, and 180-365 days). Cumulative gaps add up the incremental gaps from maturity bucket to bucket. |
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Measuring interest rate sensitivity and the dollar gap
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Gap, interest rates, and profitability:
The change in the dollar amount of net interest income (NII) is: NII = RSA$( i) - RSL$( i) = GAP$( i) Example: Assume that interest rates rise from 8% to 10%. NII = $55 million (0.02) - $35 million (0.02) = $20 million (0.02) = $400,000 expected change in NII Defensive versus aggressive asset/liability management: Defensively guard against changes in NII (e.g., near zero gap). Aggressively seek to increase NII in conjunction with interest rate forecasts (e.g., positive or negative gaps). Many times some gaps are driven by market demands (e.g., borrowers want long-term loans and depositors want short-term maturities). |
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Problem #1 with Dollar Gap Management
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Time horizon problems related to when assets and liabilities are repriced. Dollar gap assumes they are all repriced on the same day, which is not true.
For example, a bank could have a zero 30-day gap, but with daily liabilities and 30-day assets NII would react to changes in interest rates over time. A solution is to divide the assets and liabilities into maturity buckets (i.e., incremental gap). |
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Problem #2 with Dollar Gap Management
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Correlation with the market rates on assets and liabilities is 1.0. Of course, it is possible that liabilities are less correlated with interest rate movements than assets, or vice versa.
A solution is the Standardized gap. For example, assume GAP$ = RSA$ - RSL$ = $200 (com’l paper) - $500 (CDs) = -$300. Assume the CD rate is 105% as volatile as 90-day T-Bills, while the com’l paper rate is 30% as volatile. Now we calculate the Standardized Gap = 0.30($200) - 1.05($500) = $60 - $525 = -$460, which is much more negative! |
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Problem #3 with the Dollar Gap
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Focus on net interest income rather than shareholder wealth.
Dollar gap may be set to increase NIM if interest rates increase, but equity values may decrease if the value of assets fall more than liabilities fall (i.e., the duration of assets is greater than the duration of liabilities). Financial derivatives could be used to hedge dollar gap effects on equity values. While GAP$ can adjust NIM for changes in interest rates, it does not consider effects of such changes on asset, liability, and equity values. |
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Study slide on how changes in interest rates affect asset, liability, and equity values. And the example on Dollar Gap
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okay? good.
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Defensive and aggressive duration gap management:
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If you think interest rates will decrease in the future, a positive duration gap is desirable -- as rates decline, asset values will increase more than liability values increase (a positive equity effect).
If you predict an increase in interest rates, a negative duration gap is desirable -- as rates rise, asset values will decline less than the decline in liability values (a positive equity effect). Of course, zero gap protects equity from the valuation effects of interest rate changes -- defensive management. Aggressive management adjusts duration gap in anticipation of interest rate movements. |
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Problems with duration gap:
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Overly aggressive management that “bets the bank.” This happened to First Pennsylvania Corp. in late 1970s. With rates high at the end of an expansion, it bought long-term securities with short-term borrowed funds (negative dollar gap, positive duration gap). However, instead of rates falling, they shot up further, causing both negative NIMs and losses on equity leading to bankruptcy. Moral: don’t bet the bank on interest rates!
Any duration analysis assumes that the yield curve is flat and shifts in the level of interest rates imply parallel shifts of the yield curve. In reality, the yield curve is seldom flat, and short-term and long-term interest rates have different volatilities or shifts over time. Average durations of assets and liabilities drift or change over time and not at the same rates. At one point the duration gap may be 2.0 but one year later it may be only 0.5. Some experts advise rebalancing to keep the duration gap in a target range over time. |
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Other issues in duration analyses
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Simulation models
Examine different “what if” scenarios about interest rates and asset and liability mixes in gap management -- stress testing. Credit risk Gap management can affect credit risk. For example, if a bank decides to increase its use of variable rate loans (to obtain a positive dollar gap in anticipation of an interest rate increase in the near future), as rates do rise, credit risk increases due to fact that some borrowers may not be able to make the higher interest payments. Liquidity risk Changes in liquid assets and liabilities management of liquidity would no doubt affect dollar and duration gaps. |
