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51 Cards in this Set

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Loanable funds theory

Factors which influence the supply and demand for loanable funds are drivers of the rate of interest.




Supply: economic growth, savings rate etc




Demand: households, firms, Govt.

Liquidity Premium Theory

Investors will only hold long-term maturities if theyare offered a premium to compensate for future uncertainty.

Implications of Different Yield Curves




(x axis: YTM, y axis: Time To maturity)

(a) Upward sloping = normal/econ growth


▫Ifthe yield curve is upward sloping, then revenues from longer-term assets willoutstrip expenses from shorter-term liabilities.


▫Theresult will normally be a positive net interest margin (interest revenuesgreater than interest expenses).


(b) Downward= heading towards recession


(c) Flat= IR likely to be stable.


•Incontrast, a relatively flat (horizontal) or negatively sloped yield curve oftengenerates a small or even negative net interest margin.

Interest Rate Hedging & the NetInterest Margin

In order to protect profits againstadverse interest rate changes, management seeks to hold fixed the financialfirm’s net interest margin.




NIM= Net Interest Margin


Total Earning Assets

Interest Sensitive Gap





(Interest-Sensitive Assets) - (Interest-Sensitive Liabilities)





Repriceable (Interest Sensitive) and Non-Repriceable Assets

Repriceable Assets:


  • Short-term securities issued by Govt. and private borrowers.
  • Short-term loans made to customers.
  • Variable rate loans and securities



Non-Repriceable Assets:


  • Cash in vault and deposits at central bank (legal reserves).
  • Long-term loans at fixed interest rate
  • Long-term securities carrying fixed rate
  • Buildings and equipment.

Repriceable (Interest Sensitive) and Non-Repriceable Liabilities

Repriceable Liabilities:



  • Borrowings from money market (i.e. federal funds).
  • Short-term savings accounts
  • Money-market deposits



Non-Repriceable Liabilities:



  • Demand deposits (which pay no interest, or a fixed rate).
  • Long-term savings and retirement accounts
  • Equity capital provided by owners.

Asset-Sensitive Bank

ISG > 0 Asset-Sensitive Bank




=> Rising interest rates is good for this bank.


=> Interest Rate Rises => NIM rises

Relative IS Gap

(IS gap) / (Size i.e. Total Assets)




IS gap > 0 asset sensitive


IS gap < 0 liability sensitive

Interest Sensitivity Ratio (ISR)

ISA / ISL




if ISR > 1 asset sensitive


if ISR < 1 liability sensitive




▫Onlyif interest-sensitive assets and liabilities are equal is a financialinstitution relatively insulated from interest rate risk.

Maturity buckets

Many institutions usecomputer-based techniques in which their assets and liabilities are classifiedas due or repriceable today, during the coming week, in the next 30 days, andso on.

Eliminating IS GAPs




Positive Gap




Negative Gap

Positive:



  1. Do nothing (interest rates might rise or be stable.
  2. Extend asset maturities or shorten liability maturities.
  3. Increase interest-sensitive liabilities or reduce interest-sensitive assets



Negative:



  1. Do nothing (interest rates might fall or be stable).
  2. Extend liability maturities or shorten asset maturities.
  3. Increase interest-sensitive assets, or reduce interest-sensitive liabilities.


Problems with IS gap management


  • Interest paid on liabilities tends to move faster than interest rates earned on assets.
  • Interest rate attached to bank does not move at same speed as market interest rates.
  • Basically: speed and magnitude of A&L interest rate sensitivity varies.

Duration Gap Management

Duration isthe Weighted Average Maturity of a Promised Stream of Future Cash Flows.




Duration Gap:




Dollar-weighted duration of asset portfolio -


Dollar-weighted duration of liability portfolio.

Dollar-Weighted Asset Duration

= (Duration of each asset x market value of each asset) / (Total Market value of all assets)



Positive Leverage-Adjusted Duration Gap

If interest rates rise, net worth will decrease




If interest rates falls, net worth will increase

Limitations of Duration Gap Management

•Findingassets and liabilities of the same duration can be difficult.




•Someassets and liabilities may have patterns of cash flows that are not welldefined




•Customerprepayments may distort the expected cash flows in duration




•Customerdefaults may distort the expected cash flows in duration




•ConvexityProblems (i.e. Duration Assumes a parallel shift in yield curve which is notthe case since the short end of yield curve fluctuates more than the long end)

Interest Rate Option




Interest Rate Swap



Interest Rate Option:


Grants the holder of the option the right, but not the obligation to buy or sell (specific financial instruments) at an agreed price.




Interest Rate Swap:


A contract between two parties to exchange interest payments in an effort to save money and hedge against interest-rate risk.


-> The principal ammount of a loan is not exchanged

Interest-Rate Collar

Acustomer who has just received a $100 million loan and asks for a collar on the loan’s prime ratebetween 11 percent and 7 percent.




Thelender will pay its customer’s added interest cost if prime rises above 11percent, while the customer reimburses the lender if prime drops below 7percent.

Managing Credit Risk:

–Screenand monitor loan applicants to assess creditworthiness


–Chargeinterest rates commensurate with the riskiness of the borrower


–Diversifytheir lending to reduce unsystematicrisk oflending too a sector or firm.

Loan Sales:

-Wayto Rid the Bank of Lower-Yielding Assets to Make Room for Higher-YieldingAssets when Interest Rates Rise.


- Increase marketability and liquidity in assets


- Eliminate credit and market risk


- Generate fee income (i.e. by enforcing contracts)


- Diversify loan portfolio.

Securitizationof Loans

ThePooling of a Group of Similar Loans and Issuing Securities Against the PoolWhose Return Depends on the Stream of Interest




- diversifies bank's credit exposure


- creates liquid assets out of illiquid assets


- transforms these assets into new capital sources


- allows bank to generate fee income



Disadvantagesof Securitization

Problems with Securitization


•PrepaymentRisk


•CreditCrisis of 2007-2009 showed that the “bankruptcy remote” SPE arrangements canget into trouble if the underlying loans go bad




Regulators Concerns


•Riskof Having to Come Up with Large Amounts of Liquidity Quickly to MakePayments To Investors Holding Securities(Can create a Liquidity Intermediation problems)




•Riskof Agreeing to Serve as Underwriter for Securities


•Riskof Acting as Credit Enhancer and Underestimating Need for Loan Reserves


•Riskthat Unqualified Trustees Will Fail to Protect Investors


•Riskof Loan Servicers Being Unable toSatisfactorily Monitor Loan Performance and Collect Monies Owed


•Inlight of the credit crisis, also focus on the impact of securitization on the remaining portfolio of loans that arenot securitized (i.e. only poor loans stay on Balance Sheet).

Credit Swaps




Credit Options

Credit Swaps:


- Two lenders agree to swap a portion of their customer's loan payments


- Can help further spread out each other's risk (diversify).




Credit Options:


- Guard against losses in value of a credit asset or helps offset higher borrowing costs due to changes in credit rating of borrower.

CollateralizedDebt Obligations (CDOs)

ContainPools of High-Yield Corporate Bonds, Stocks or Other Financial InstrumentsContributed by Businesses Interested In Strengthening Their Balance Sheets andRaising New Funds.




CDOare Different to Regular Securitisation in several Ways


•They could buy other asset backed securities rather than directly holding loans making it very difficult to measure risk.




TheCredit and Liquidity Crisis of 2007-2009 has Exposed The Complexity of TheseInstruments

Why hold Investment/Security Portfolios

Investment security portfolios helpto


▫Stabilizethe bank’s income (offer yield)▫Providebackup source of liquidity


▫Serveas collateral (E.g. REPO market)


▫Provideflexibility


▫Offsetcredit risk exposure


▫Providegeographic diversification


▫Reducetax exposure


▫Hedgeagainst interest rate risk


▫Dressup a bank’s balance sheet

Ladder or Spaced Maturity Policy



Strategy:


Divide investment portfolio equally among all maturities acceptable to the institution




Advantage:


- Reduces investment income fluctuations


- Requites little management expertise

Front- End Policy




Back- End Policy

Front: investments are short-term.


Advantages:


- Strengthens liquidty position


- Avoids large capital losses if market interest rates rise.




Back: investments are long-term.


Advantages:


- Maximises income potential if market interest rates fall.





Barbell investment portfolio strategy



Security holdings are divided between long-term and short-term investments.




-> Addresses liquidity and has higher earning potential.



Rate-expectations Approach

Changing the mix of investment maturities as the interest-rate outlook changes.




=> Shift toward long-term if interest rates are expected to fall.


=> Shift toward short-term if interest rates are expected to rise.

The Challenge of LiquidityManagement

Thereis a trade-offbetween liquidity and profitability:




=> The moreresources are tied up in readiness to meet demands for liquidity, the lower isthat financial firm’s expected profitability.

Estimating Liquidity Needs:


Sources and Uses of Funds Approach

Estimated Liquidity deficit/ surplus =


Estimated change in deposits - estimated change in loans.




Estimating Liquidity Needs:


Structure of Funds Approach

A bank’s deposits and other sources of funds divided into categories.




2. Suppose that a thriftinstitution’s liquidity division estimates that it holds $19 million in hotmoney deposits and other IOUs against which it will hold an 80 percentliquidity reserve,


$54 million in vulnerable funds against which it plans tohold a 25 percent liquidity reserve,


and $112 million in stable or core fundsagainst which it will hold a 5 percent liquidity reserve.


Thethrift expects its loans to grow 8 percent annually; its loans currently total$117 million but have recently reached $132 million. If reserve requirements on liabilities currentlystand at 3 percent, what is this depositoryinstitution’s total liquidity requirement?




Total LiquidityRequirement


= 0.80 ($19 million − 0.03 × $19million)


+ 0.25 ($54 million − 0.03× $54 million)


+ 0.05 ($112 million − 0.03× $112 million)




+ $132 million × 0.08 +($132 million − $117 million) = $58.831 million

Estimating Liquidity Needs


MarketSignals and Banks Runs

1. Publicconfidence


2. Stockprice behaviour


3. Riskpremiums on CDs and other borrowings 4. Creditdefault swaps


5. Losssales of assets (fire sales)


6. Meetingcommitments to credit customers


7. Borrowingsfrom the central bank

Transaction Deposit




Non-Transaction Deposit

Transaction (payment or demand) deposit:


- making payment on behalf of customer


- provider is required to honour any withdrawals immediately.




Non-Transaction deposit:


- longer term


- higher interest rates


- generally less costly to process and manage.



Deposit Pricing

Unit Price Charged per deposit=


Operating expense + estimated overhead + planned profit margin from each unit sold






e.g. Op cost= 4.87, overhead cost = 1.21




$4.87 + $1.21 + [0.10 × ($4.87 + $1.21)] =$6.688

Conditional Pricing

Could be based on:



  • Number of transactions through account
  • Average account balance
  • Maturity of deposits (days, weeks, or years etc)


Deposit Pricing sensitive to two factors:

- The type of customer


- The cost to the bank of serving different types of customers

Unbanked and Underbanked

Unbanked: no deposits or loans


Underbanked: Having access to some critical services but not others.

Tasks of Capital

1. Providesfunds to help institutions get started 2. Providesa cushion against the risk of failure


3. Promotes public confidence


4. Provides funds for growth


5. Regulator for growth


6. Regulatory tool to limit risk exposure.

Reasons for Capital Regulation

  • To limit risk of failures
  • To preserve public confidence
  • To limit losses to the Govt. and other institutions (arising from deposit insurance claims)

The Basel Agreement on International Capital Standards

- An international agreement on new capital standards.


- Reduce inequalities in capitalrequirements among different countries.


- Promote fair competition


- Expansion of OBS commitments




=>8% of Total capital must be held against risk-weighted assets (4% T1)

Basel 1:


Tier 1 (core) Capital




Tier 2 (supplement) Capital

T1


  • Common stock and surplus
  • Undivided profits (retained earnings)
  • qualified (noncumulative, perpetual) preferred stock.



T2


  • Allowance (reserves) for loans and losses
  • Subordinated debt
  • Capital instruments
  • Intermediate-term preferred stock
  • Equity notes





Basel 1 criticism?




Theoriginal Basle accord was criticised forfocusing too narrowly on lending practices and not enough on market risk.

0 Percent Risk Weighted Catergory


  • Cash
  • U.S. Treasury Securities

20 Percent Risk Weighted Catergory


  • Deposits at Domestic Banks
  • Credit-equivalent amounts of SLCs backing municipal bonds

50 Percent Risk Weighted Catergory


  • Mortgage loans

100 Percent Risk Weighted Catergory

  • Loans to private corporations

  • Credit-equivalent amounts of long-term unused loan commitments to private corporations.

Tier 1 Capital Risk-Based Capital Ratio




Total risk-based capital ratio

Tier 1 Capital


Total risk-weighted assets




Tier 1 + Tier 2


Total risk-weighted assets

Capital Requirements Attached toDerivatives




Counterparty risk

•TheBasel I capital standards were adjusted to take account of the risk exposurebanks may face from derivatives, which sometimes expose a bank to counterparty risk.




The danger that a customer will fail topay or to perform, forcing the bank to find a replacement contract with anotherparty that may be less satisfactory.

Raising Capital Externally

1. Selling common stock


2. Selling preferred stock


3. Issuing debt capital


4. Selling assets


5. Swapping stock for debt securities