EOFI Module 2 Slides PDF

Economics of financial intermediation Session 11 – Banking and the management of financial institutions (1) Mascia Bedendo Overview The Bank Balance Sheet Basics of Banking General Principles of Bank Management Liquidity management 2 The bank balance sheet The Balance S...

Economics of financial intermediation Session 11 – Banking and the management of financial institutions (1) Mascia Bedendo Overview The Bank Balance Sheet Basics of Banking General Principles of Bank Management Liquidity management 2 The bank balance sheet The Balance Sheet is a list of a bank’s assets and liabilities Total assets = total liabilities + capital A bank’s balance sheet lists sources of bank funds (liabilities) and uses to which they are put (assets) Banks invest these liabilities (sources) into assets (uses) in order to create value for their capital providers 3 The bank balance sheet – Unicredit Group EUR millions 4 The bank balance sheet – Unicredit Group EUR millions 5 The bank balance sheet Balance sheet of all U.S. commercial banks for 2016 (items as % of total assets) 6 The bank balance sheet: Liabilities Checkable Deposits Accounts that allow the owner (depositor) to write checks to third parties non-interest earning as well as interest earning checking accounts Payable on demand Safe and liquid, but offer low interest High servicing costs for banks, low interest costs 7 The bank balance sheet: Liabilities Nontransaction Deposits Accounts from which the depositor cannot write checks savings accounts time deposits (e.g., certificates of deposit) Penalties for early withdrawal Higher cost of funding, but more stable source of funding for bank than checkable deposits 8 The bank balance sheet: Liabilities Checkable deposits + Nontransaction deposits account for the majority of bank borrowings in commercial banks Depositors are households and nonfinancial firms 9 The bank balance sheet: Liabilities Borrowings Funds from the central bank, other banks, and corporations loans from the central bank fed funds / other interbank loans (from other banks) interbank offshore deposits (from other banks), repurchase agreements (“repos”) commercial paper and notes/bonds More volatile than deposits Their importance has grown over time 10 The bank balance sheet: Liabilities Other liabilities Financial liabilities held for trading Hedging instruments Tax liabilities Other (e.g. employee benefits, etc.) 11 The bank balance sheet: Equity Bank Capital It is the source of funds supplied by the bank owners Regulatory requirements impose minimum capital ratios for banks Bank capital is much more complex than capital in a nonfinancial firm More on this later on in the course 12 The bank balance sheet: Assets Reserves Funds held in an account with the central bank (vault cash as well) Required reserves represent what is required by law under current required reserve ratios Required reserves are computed as a percentage of deposits Any reserves beyond this minimum level are called excess reserves 13 The bank balance sheet: Assets Cash items in Process of Collection: Checks deposited at the bank (funds from other bank have not yet been transferred) Deposits at Other Banks: Usually deposits from small banks at larger banks Reserves, Cash items in Process of Collection, and Deposits at Other Banks are collectively referred to as Cash Items Very low interest income Very liquid 14 The bank balance sheet: Assets Securities: Government/agency debt Municipal debt (mostly U.S.) Other (non-equity) securities, e.g. corporate bonds Short-term Treasury debt is a secondary reserve because of its high liquidity Securities must be of good credit quality (investment-grade) Good source of income when interest rates are high 15 The bank balance sheet: Assets Loans: Interbank loans Business loans Retail loans (e.g. auto loans, student loans, credit card loans) Mortgages Loans represent the major source of a bank’s income Not very liquid (with the exception of interbank loans that have short maturity) 16 The bank balance sheet: Assets Other Assets Financial assets held for trading Hedging instruments Real assets: bank buildings computer systems other equipment goodwill 17 Asset transformation It is helpful to understand some of the simple accounting associated with the process of banking Think beyond the debits/credit - and try to see that banks engage in asset transformation Asset transformation is, for example, when a bank takes your savings deposits and uses the funds to make, say, a mortgage loan Banks tend to “borrow short and lend long” (in terms of maturity) 18 Basics of Banking Accounting Suppose you open a bank account and deposit $100 cash into First National Bank: Alternatively, if you had opened a bank account and deposited a check for $100: Either way, the bank sees an increase in deposits for $100 and an increase in cash and reserves for $100 19 Basics of Banking Accounting If you deposit a check written on an account with Second National Bank, the accounting at the two banks is as follows: Interbank operations are settled on interbank circuits 20 Basics of Banking Accounting Conclusion: When bank receives deposits, cash & reserves increase by equal amount When bank loses deposits, cash & reserves drop by equal amount 21 Basics of Banking Accounting In reality banks are obliged to keep a fraction of their deposits as required reserves (suppose 10%) Let’s go back to the case where you open a bank account and deposit $100 cash into First National Bank 22 Basics of Banking Accounting $10 of the deposit must remain with the central bank to meet reserve requirements Bank is free to work with the $90 The bank loans the $90 to its customers 23 Basics of Banking Accounting This allows the bank to earn a profit Deposits pay out very low or no interests… … but they are costly to service Required and excess reserves earn virtually no interests Loans to customers are instead quite profitable 24 General principles of bank management Now let’s look at how a bank manages its assets and liabilities to earn the highest possible profit The bank has four primary concerns: Liquidity management Asset management Managing credit risk Managing interest-rate risk Liability management Managing capital adequacy 25 Liquidity management Banks have to ensure that they have enough liquidity to face deposit outflows Example: Suppose that the First National Bank’s initial balance sheet is as follows (the bank has reserve requirements of 10% of deposits): 26 Liquidity management Deposit outflow of $10 million With 10% reserve requirement, bank still has reserves of $10 million ($9 mln in required reserves and $1 mln in excess reserves): no liquidity issues and no changes in other parts of its balance sheet First National Bank Assets Liabilities Reserves $10 million Checkable deposits $90 million Loans $80 million Bank capital $10 million Securities $10 million 27 Liquidity management Suppose instead that the First National Bank decided not to keep any excess reserves (the $10 million are instead invested in additional loans). The initial balance sheet is as follows: 28 Liquidity management Deposit outflow of $10 million With 10% reserve requirement and no excess reserves, bank has a shortfall – not enough required reserves! 29 Liquidity management How can the bank recover the $9 million? Borrow from other banks Sell securities Borrow from the central bank Reduce loan portfolio 30 Liquidity management Borrowing from other banks: 31 Liquidity management Sale of securities: 32 Liquidity management Borrowing from the central bank: 33 Liquidity management Reduction in loan portfolio: 34 Bank runs Deposit withdrawals can be very dangerous for banks In the extreme scenario, they can lead to a bank run 35 Bank runs Bank runs occur when depositors withdraw their deposits en masse fearing that the bank may become insolvent in the near future Self-fulfilling prophecy in case the bank is not in deep financial trouble Many examples in the 1930s More recent examples: Northern Rock in 2007, SVB and CS in 2023 36 Bank runs Reading on Northern Rock for next session. Answer the following questions: Q1: How did Northern Rock finance its growth? Q2: What are the most stable sources of financing for a mortgage bank? Were the funding sources chosen by Northern Rock stable? Q3: What funds were pulled out first, thus causing liquidity problems to Northern Rock? Why did those lenders pull out? Was the business of Northern Rock considered to be particularly risky? Q4: Were retail depositors responsible for the bank run? Did all retail depositors act in the same way? Q5: Why did retail depositors run to withdraw their deposits? Aren’t retail deposits insured? 37 Session readings Mishkin, Eakins, Financial markets and institutions, 9th ed. Chapter 17 38 Economics of financial intermediation Session 12 – Banking and the management of financial institutions (2) Mascia Bedendo Overview A liquidity crisis: The collapse of Northern Rock Asset Management Liability Management Capital Adequacy Management Bank Income Statement and Bank Profitability 2 Asset Management Asset Management is the attempt to: Earn the highest possible return on assets… while minimizing the risk… and making adequate provisions for liquidity Four strategies: 1. Get borrowers with low default risk who pay high interest rates 2. Buy securities with high return and low risk (see ABS leading to the financial crisis) 3 Asset Management Four strategies (cont’d): 3. Diversify: – Diversify the portfolio of securities – Diversify the loan portfolio (geographically, by sector of activity) 4. Manage liquidity to ensure reserves are met without bearing large costs 4 Liability Management Liability Management is the active management of the funding sources, from deposits, to CDs, to other debt 1. Important since 1960s (prior to that, almost all funding came from deposits) 2. Banks no longer primarily depend on deposits 3. When loan opportunities arise, banks can borrow from other banks or issue CDs or notes to acquire funds 5 Asset & Liability Management Banks manage both sides of the balance sheet together, whereas it was more separate in the past The liability side was taken as given and only the asset side was actively managed Most banks now manage both sides via the asset-liability management (ALM) committee This explains the increased use of CDs, interbank loans, and notes over checkable deposits in recent decades 6 Capital adequacy management Capital adequacy management is the management of the amount of capital the bank needs to hold in order to: 1. Prevent bank failure 2. Guarantee a good return on equity for investors 3. Satisfy minimum capital requirements imposed by regulators 7 Capital adequacy management: A story of two banks 8 Capital adequacy management: A story of two banks What happens if these banks make loans or invest in securities (say, subprime mortgage loans, for example) that end up losing money? Let’s assume both banks lose $5 million from bad loans 9 Capital adequacy management: A story of two banks Low capital bank is now insolvent (i.e. negative equity) 10 Capital adequacy management: A story of two banks Why don’t banks hold a lot of capital to prevent insolvency? The higher is bank capital, the lower is return on equity (ROE) (Return on assets) ROA = Net Profit (after taxes)/Total assets (Return on equity) ROE = Net Profit (after taxes)/Equity Capital (Equity Multiplier) EM = Total assets/Equity Capital ROE = ROA x EM As capital increases, EM falls, ROE falls Tradeoff between safety (high capital) and ROE Banks also hold capital to meet capital requirements 11 The practicing manager Strategies for Managing Capital: what should a bank manager do if he/she feels the bank is holding too much capital? Buy back some of the bank’s stock Increase dividends to reduce retained earnings Increase asset growth via extra debt Reversing these strategies will help a manager if he/she feels the bank is holding too little capital Issue stock Decrease dividends to increase retained earnings Slow asset growth (retire debt) 12 The practicing manager The slowdown in growth of credit triggered a crunch in 2007-2009 - credit was hard to get. What caused the credit crunch? Housing boom and bust led to large bank losses, including losses on SIVs which had to be recognized on the balance sheet The losses reduced bank capital Banks were forced to either (1) raise new capital or (2) reduce lending Guess which route they chose? Why would banks be hesitant to raise new capital (equity) during an economic downturn? 13 Measuring bank performance Measuring bank performance requires a look at the income statement: Operating Income Operating Costs Net Operating Income This is different from a manufacturing firm’s income statement 14 The income statement – Unicredit Group 15 EUR millions Measuring bank performance Operating Income comes from a bank’s ongoing operations The largest component are the interests on loans Net interest = Interests on loans and other assets - Interest expenses on debt The Net interest fluctuates with the level of interest rates Very high in the 1980s, and also nowadays Noninterest income is mostly generated by fees and commissions 16 Measuring bank performance Operating Costs/Expenses are the expenses incurred in conducting the bank’s ongoing operations Interest expenses on debt are directly subtracted from interests on loans to derive Net interest Biggest component of noninterest expenses are salaries, rent, purchases of equipment, etc. 17 Measuring bank performance Operating Income - Operating Costs/Expenses gives the Operating profit (loss) Net provisions for loan losses are provisions made to face likely losses on the loan portfolio Provisions for loan losses typically peak during an economic recession Operating profit (loss) – Net provisions for loan losses = Net operating income (loss) Net income is computed by subtracting other residual and extraordinary items as well as taxes 18 Measuring bank performance Measure of overall bank profitability: Return on Assets = ROA = Net Income/Total Assets Measure of profitability for shareholders: Return on Equity = ROE = Net Income/Equity Capital Measure of profitability in the core business of commercial banks: Net Interest Margin = NIM = [Interest Income − Interest Expenses]/Total Assets NIM reflects quality of asset-liability management 19 Challenges to bank profitability over recent years Banks have been facing several challenges in terms of profitability over the last decade: Low interest rate levels have narrowed the net interest margin for years, which has now bounced back to unprecedented levels Prolonged economic recessions have increased the provisions for loan losses (see Covid and the potential upcoming recession) Competition from other banks and non-banks has decreased fees and commissions => reduction in operating costs through digitalization, layoffs, branch closures, etc. to preserve profitability 20 Challenges to bank profitability over recent years Over the past 2-3 years, banks have enjoyed record profits Can you see why? Net interest income? Net operating income? Loan portfolio? Capital? 21 Session readings Mishkin, Eakins, Financial markets and institutions, 9th ed. Chapter 17 22 Economics of financial intermediation Session 13 – Risk Management in Banks (I) Mascia Bedendo Overview An overview of bank risks Interest rate risk Credit risk Liquidity risk Market risk Operational risk Interest rate risk: Gap analysis 2 A bank’s balance sheet 3 Risks incurred by banks Banks and other financial institutions face a number of risks Main risks: Interest rate risk Credit risk Liquidity risk Market risk Additional risks: FX risk Operational risk 4 Interest rate risk 5 Interest rate risk Banks perform asset transformation… …By transforming short-term deposits into long-term loans The maturity characteristics of deposits/borrowings and loans are different Maturity mismatch exposes banks to interest rate risk Interest rate risk: Refinancing risk Reinvestment risk 6 Interest rate risk: Refinancing risk Example 1: Effect of an interest rate increase when the maturity of the assets exceeds the maturity of the liabilities Consider the case of a bank that issues $100 mln CDs with 1 year maturity to finance $100 mln loans with 2 year maturity The cost of funds is 9% in year 1 and the interest return on the loans is 10% per year Profit for first year = (10%-9%)x100mln = $1mln Profit for second year is uncertain, as the bank will have to refinance itself for an additional year: If at the end of the first year interest rates on CDs increase to 11% the bank will incur a loss in the second year (10%-11%)x100mln = - $1mln Refinancing risk 7 Interest rate risk: Reinvesment risk Example 2: Effect of an interest rate decrease when the maturity of the liabilities exceeds the maturity of the assets Consider the case of a bank that issues $100 mln CDs with 2 year maturity to finance $100 mln loans with 1 year maturity The cost of funds is 9% in each of the two years and the interest return on the loans is 10% for the first year Profit for first year = (10%-9%)x100mln = $1mln Profit for second year is uncertain: If at the end of the first year interest rates on loans decrease to 8% the bank will incur a loss in the second year (8%- 9%)x100mln = -$1mln Reinvestment risk 8 Interest rate risk Maturity matching helps mitigate interest rate risk Difficult to achieve as it is in contrast with the nature of asset transformers of financial institutions 9 Credit risk 10 Credit risk The business of financial institutions is making loans The risk with loans is that the borrower will not repay Credit risk is the risk that a borrower will not repay a loan according to the terms of the loan, either defaulting entirely or making late payments of interest or principal Loan losses are charged off against the equity capital (see Session 12) The largest source of risk for banks It also affects the securities portfolio (in case of default of the issuers) Particularly severe in times of recession 11 Liquidity risk 12 Liquidity risk Banks are exposed to liquidity risk as depositors can demand immediate cash for the financial claims they hold with the bank Unprofitable to hold large cash reserves to face potential liquidity problems Discussed in Session 11 In normal conditions not a problem, as it can be faced with: Cash reserves Sale of government bonds in portfolio Additional borrowing In a liquidity crisis (e.g. bank run) banks can be forced to: Liquidate assets at fire-sale prices Borrow from the central bank 13 Market risk 14 Market risk Market risk is the risk of incurring unexpected losses in the trading book due to changes in market prices Trading book includes financial assets and liabilities frequently bought or sold on organized markets with the purpose of generating a profit Examples include bonds, equities, FX products, derivatives Trading book recorded at fair value (i.e. market prices) Different from assets and liabilities held for long-term investment, funding or hedging purposes –recorded at book value Changing market conditions (interest rates, fx rates, stock prices, commodity prices, etc.) translate into a change in the market prices of the assets and liabilities in the trading book 15 Foreign exchange risk Foreign exchange risk is the risk that exchange rate changes can adversely affect the value of a bank’s assets and liabilities denominated in foreign currency More prominent for large international banks that: Lend to foreign borrowers Borrow funds in different currencies 16 Operational risk Operational risk is the risk of losses resulting from inadequate or failed internal processes, people, and systems, or from external events The definition includes: People risks: losses arising from employees’ misconduct (e.g. unauthorized trading) Technology and processing risks: for example, IT disruptions, cyber attacks Legal risks: losses arising from legal fines imposed on the bank (e.g. the Libor scandal) Regulatory risks: losses arising from new potential regulation For an overview: https://www.risk.net/risk-management/7800126/top-10- operational-risks-for-2021 17 Operational risk: Examples Some examples of operational losses: Mitsubishi Corporation, $320m, November 2019 Mitsubishi Corporation subsidiary Petro-Diamond Singapore lost $320 million through employee’s unauthorised crude oil derivatives transactions after oil prices dropped. The employee engaged in the unauthorised transactions between January 2019 and August 2019, disguising them as hedge transactions ABN AMRO, €226m, November 2019 ABN AMRO provisioned €226 million for a customer due diligence remediation programme. This was instigated by the Dutch central bank after ABN AMRO had given the majority of customers a neutral risk profile Deutsche Bank, $16.2m, November 2019 The SEC fined Deutsche Bank $16.2 million for hiring relatives of foreign government officials in China and Russia. The practice occurred between 2006 and 2014 with the aim of obtaining the officials’ investment banking business 18 Climate risk Recall what we discussed in Session 4 about climate risk Climate risk has two components: Physical risk: losses arising from natural events (e.g., floods, fires, windstorms, etc.) – location plays a role Transition risk: losses arising from transitioning to a carbon-neutral economy (e.g., carbon tax, technological changes, new regulation, reputational losses, etc.) – sector of activity plays a role Climate risk exposes banks to potential losses How would you classify climate risk? As a risk of its own? As a source of interest-rate, credit, liquidity, market and/or operational risk? 19 Risk measurement and management Banks are required to set aside capital to face their risks More on bank regulation later on in the course As a result, banks involve in: Risk measurement, aimed at measuring their exposure to the individual sources of risk Risk management, aimed at mitigating their risk exposure 20 Interest rate risk measurement To see how financial institutions can measure and manage interest rate risk exposure, we will examine the balance sheet for First National Bank We will investigate two tools: 1. Income Gap Analysis 2. Duration Gap Analysis which are commonly used by financial managers in interest rate risk management 21 Balance sheet of First National Bank 22 Balance sheet of First National Bank (cont’d) assets 23 Income Gap Analysis Income Gap Analysis: measures the sensitivity of a bank’s current year net income to changes in interest rates Requires determining which assets and liabilities will have their interest rate change as market interest rates change Let’s see how that works for First National Bank 24 Determining Rate Sensitive Items for First National Bank Assets – assets with maturity less – short-term CDs than one year – federal funds – variable-rate mortgages – short-term borrowings – short-term commercial loans – portion of checkable – portion of fixed-rate deposits (10%) mortgages (say 20%) – portion of savings (20%) Liabilities – money market deposits – variable-rate CDs 25 Determining Rate Sensitive Items for First National Bank Rate-Sensitive Assets = $5m + $ 10m + $15m + 20%  $10m RSA = $32m Rate-Sensitive Liabs. = $5m + $10m + $15m + $5m + $10m + + 10%  $15m + 20%  $15m RSL = $49.5m if i ↑ by 5 percentage points (e.g. from 5% to 10%)  Asset Income = +5%  $32.0m = +$ 1.6m Liability Costs = +5%  $49.5m = +$ 2.5m Income = $1.6m − $2.5m = −$0.9m 26 Income Gap Analysis If RSL > RSA, i ↑ results in: NIM ↓, Income ↓ GAP = RSA − RSL = $32.0m −$49.5m = −$17.5m DIncome = GAP x Di = −$17.5m x 5% = −$0.9m This is essentially a short-term focus on interest-rate risk exposure 27 Session readings Mishkin, Eakins, Financial markets and institutions, 9th ed. Chapter 23 28 Economics of financial intermediation Session 14 – Risk Management in Banks (II) Mascia Bedendo Overview Interest rate risk (cont’d): Duration Gap Analysis Managing interest rate risk On-balance sheet With derivatives 2 Interest rate risk measurement In the previous session we analyzed a first measure of interest rate risk: Income Gap Analysis It is focused on the short-term exposure of a bank’s balance sheet to interest rate changes… …and measures the sensitivity of bank net income to changes in interest rates  Net Interest Income = GAP x i where GAP = RSA − RSL 3 Drawbacks of income gap analysis The Income Gap Analysis suffers from three major weaknesses: 1. Market value effects A change in interest rates affects the immediate interest received or paid on assets and liabilities, but also the present value of the cash flows on assets and liabilities The income gap analysis only investigates the first effect and ignores the second Partial and short-term measure of the overall interest rate risk exposure 2. Different maturity buckets The income gap analysis ignores the maturity distribution of assets and liabilities that are not classified as rate-sensitive A possible solution: Maturity bucket approach that measures the gap for several maturity subintervals 4 Drawbacks of income gap analysis The Income Gap Analysis suffers from three major weaknesses: 3. Runoffs and prepayments Virtually all assets and liabilities pay some interest and/or principal back in any given year (even rate insensitive assets or liabilities) Banks normally estimate a percentage of mortgages that can be repaid or fixed term deposits that will be withdrawn The actual percentages may be significantly different 5 Maturity bucket approach 6 Maturity bucket approach 7 Maturity bucket approach Estimate rate-sensitive assets and liabilities for horizons longer than one year For example, we can compute the potential change in income between 1 and 2 years Rate-sensitive assets and liabilities are the ones that reprice between 1 and 2 years The bank manager also expects 20% of fixed-rate mortgages to be repaid between 1 and 2 years and 10% of checkable deposits + 20% of savings deposits to be rate sensitive over this period 8 Determining Rate Sensitive Items between 1 and 2 years Rate-Sensitive Assets = $5m + $ 10m + 20%  $10m RSA = $17m Rate-Sensitive Liabs. = $5m + $5m + 10%  $15m + 20%  $15m RSL = $14.5m GAP = 17-14.5=$2.5 mln if i ↑ by 1 percentage point (e.g. from 5% to 6%)   Net Income in 1 to 2 years = $2.5m x 0.01 = $25,000 9 Duration Gap Analysis Duration Gap Analysis can help deal with the first two drawbacks Duration Gap Analysis measures the sensitivity of the market value of a bank’s net worth to changes in interest rates It requires determining the duration for all assets and liabilities whose market value will change as interest rates change It offers a long-term perspective on interest rate risk exposure Let’s see how this looks for First National Bank 10 Duration of First National Bank’s assets Amount Duration Weighted Duration Blank ($ millions) (years) (years) Assets Blank Blank Blank Reserves and cash items 5 0.0 0.00 Securities Blank Blank Blank Less than 1 year 5 0.4 0.02 =(5x0.4)/100 1 to 2 years 5 1.6 0.08 Greater than 2 years 10 7.0 0.70 Residential mortgages Blank Blank Blank Variable rate 10 0.5 0.05 Fixed rate (30-year) 10 6.0 0.60 11 Duration of First National Bank’s assets Amount Duration Weighted Duration Blank ($ millions) (years) (years) Commercial loans Blank Blank Blank Less than 1 year 15 0.7 0.11 1 to 2 years 10 1.4 0.14 Greater than 2 years 25 4.0 1.00 Physical capital 5 0.0 0.00 Average duration Blank Blank 2.70 12 Duration of First National Bank’s liabilities Amount Duration Weighted Duration Blank ($ millions) (years) (years) Liabilities Blank Blank Blank Checkable deposits 15 2.0 0.32 =(15x2.0)/95 Money market deposit accounts 5 0.1 0.01 Savings deposits 15 1.0 0.16 CDs Blank Blank Blank Variable rate 10 0.5 0.05 Less than 1 year 15 0.2 0.03 1 to 2 years 5 1.2 0.06 Greater than 2 years 5 2.7 0.14 13 Duration of First National Bank’s liabilities Amount Duration Weighted Duration Blank ($ millions) (years) (years) Fed funds 5 0.0 0.00 Borrowings Blank Blank Blank Less than 1 year 10 0.3 0.03 1 to 2 years 5 1.3 0.07 Greater than 2 years 5 3.1 0.16 Average duration Blank Blank 1.03 14 Duration Gap Analysis Duration is additive! Duration of a portfolio is the weighted average of the duration of the individual constituents, each weighted by their share of value in the portfolio We applied the additivity property to derive the average duration of the assets and the liabilities The basic equation for determining the change in market value for assets or liabilities is: % Value Change ≈ − DUR × [Δi/(1+i)] In line with what we studied when looking at how duration helps expressing a linear relation between changes in interest rates and changes in bond value 15 Duration Gap Analysis Consider a change in interest rates from 10% to 11% We can then derive: % Change in Asset Value: −2.70 × (0.01/1.10) = −2.5% % Change in Liability Value: −1.03 × (0.01/1.10) = −0.9% Change in Asset value = −2.5% x $100m = −$2.5m Change in Liability value = −0.9% x $95m = −$0.9m Change in Net Worth: −$2.5m − (−$0.9m) = −$1.6m Hence a loss of $1.6 million Recall from the balance sheet that First National Bank has “Bank capital” totaling $5m. Following such a dramatic change in rate, the capital would fall to $3.4m 16 Duration Gap Analysis An alternative calculation involves the duration gap, defined as: 𝐿 𝐷𝑈𝑅𝑔𝑎𝑝 = 𝐷𝑈𝑅𝑎 − × 𝐷𝑈𝑅𝑙 𝐴 where: 𝐷𝑈𝑅𝑎 is the average duration of assets 𝐷𝑈𝑅𝑙 is the average duration of liabilities 𝐿 is the market value of liabilities 𝐴 is the market value of assets 17 Duration Gap Analysis In our example: 95 𝐷𝑈𝑅𝑔𝑎𝑝 = 2.70 − × 1.03 = 1.72 100 From here we can directly estimate the change in the market value of net worth (as a percentage of total assets): ∆𝑁𝑊 ∆𝑖 ≈ −𝐷𝑈𝑅𝑔𝑎𝑝 × 𝐴 1+𝑖 In our case: ∆𝑁𝑊 0.01 ≈ −1.72 × = −0.016 = −1.6% 𝐴 1.1 Since 𝐴=$100m, the bank will experience a fall in the market value of net worth of $1.6m 18 Some residual problems with gap analyses Both Income Gap Analysis and Duration Gap Analysis assume that interest rates on all maturities change by exactly the same amount Essentially we are assuming that the slope of the yield curve remains unchanged… … or, in other words, that the yield curve shifts upwards or downwards in a parallel fashion For example the yield curve shifts upwards from A to B B A 19 Some residual problems with gap analyses Additionally, the duration gap analysis implicitly assumes that interest rates for all maturities are the same (i.e. the yield curve is flat) B A These assumptions are unrealistic Yield curves are not flat… … and do not move in a parallel fashion However, gap analyses are sufficiently accurate when interest rate changes are small and yield curves are not too steep 20 Interest rate risk management Both income gap analysis and duration gap analysis indicate that First National Bank will suffer from a rise in interest rates What can the bank do? 1. Eliminate the income gap by: Increasing the amount of rate-sensitive assets to $49.5m, or Reducing the amount of rate-sensitive liabilities to $32m Either way, a change in interest rates would have no impact on next year’s net interest income 21 Interest rate risk management 2. Immunize the market value of the net worth by adjusting assets and liabilities so that the duration gap is zero If assets are easier to adjust than liabilities, the bank manager can fix 𝐷𝑈𝑅𝑎 so that 𝐷𝑈𝑅𝑔𝑎𝑝 is set to zero: 𝐿 95 𝐷𝑈𝑅𝑎 = × 𝐷𝑈𝑅𝑙 = × 1.03 = 0.98 𝐴 100 The average duration of assets should be reduced to 0.98 years Conversely, if liabilities are easier to adjust than assets, the bank manager can fix 𝐷𝑈𝑅𝑙 so that 𝐷𝑈𝑅𝑔𝑎𝑝 is set to zero: 𝐴 100 𝐷𝑈𝑅𝑙 = × 𝐷𝑈𝑅𝑎 = × 2.70 = 2.84 𝐿 95 The average duration of liabilities should be increased to 2.84 years 22 Interest rate risk management Immunization techniques may be difficult to implement in practice And costly to do in the short run The maturity (and duration) of assets and liabilities often depends upon the bank’s particular field of expertise An easier alternative to hedge against interest rate risk is to use financial derivatives Interest rate forward contracts Interest rate futures Interest rate swaps Interest rate options 23 Interest rate risk management using forwards An example of hedging using an interest rate forward contract First National Bank owns $5 million of T-bonds that mature in 2037. Because these are long-term bonds, FNB is exposed to interest-rate risk First National Bank agrees to deliver $5 million in face value of 6% Treasury bonds maturing in 2037 Rock Solid Insurance Company agrees to pay $5 million for the bonds FNB and Rock Solid agree to complete the transaction one year from today at the FNB headquarters in town FNB is hedging by reducing price risk from increases in interest rates in one year Q: Why would Rock Solid enter such contract? 24 Interest rate risk management using futures If a futures contract on the 6% T-bond with expiry 2037 is traded in the futures market, FNB can short futures instead of entering a forward contract with Rock Solid Insurance Free from counterparty risk More liquid than forward contract Example: The 6% T-bond with expiry 2037 is one of the deliverable bonds under the 1-year T-bond futures contract that trades on the CBOT. The value of one futures contract is $100,000 FNB can go short $5,000,000/$100,000 = 50 futures contracts 25 Interest rate risk management using futures In case of a perfect hedge, the payoffs from forward and futures contracts are equivalent In case interest rates increase: Loss on the underlying T-bond position Gain on the forward/futures position Gains and losses offset each other and the position is immunized from interest rate risk A perfect hedge is hard to achieve using futures contracts FNB remains exposed to basis risk (see Session 7) 26 Interest rate risk management using IRS An example of hedging using an interest rate swap FNB has more rate-sensitive liabilities than rate-sensitive assets, which is typical of commercial banks that tend to borrow short-term and lend long- term Most assets are fixed rate, while most liabilities are floating rate or repricing shortly This exposes FNB to losses if interest rates rise To mitigate this risk, FNB may wish to “convert” part of its fixed rate assets into rate-sensitive assets This can be done with an interest rate swap 27 Interest rate risk management using IRS Notional principal of $1 million Term of 10 years FNB swaps 6% payment for SOFR from Friendly Finance Company By doing this, $1m have been converted from fixed-rate assets to floating rate assets 6% Friendly FNB Finance SOFR Q: Why would Friendly Finance Co. agree to the swap? 28 Interest rate risk management using IRS Advantages and disadvantages of IRS: Very flexible Available over long horizons Usually liquid, but the market can freeze in a financial crisis Subject to counterparty risk 29 Session readings Mishkin, Eakins, Financial markets and institutions, 9th ed. Chapter 23 30 Economics of financial intermediation Session 15 – Risk Management in Banks (III) Mascia Bedendo Overview Credit risk Market risk 2 Credit risk Credit risk is the risk that a borrower will not repay a loan according to the terms of the loan, either defaulting entirely or making late payments of interest or principal Banks accept the credit risk of loans in return for an interest that (hopefully) covers the cost of funding, the potential losses arising from lending, and a profit margin Main elements of credit risk: Probability of Default of the borrower Exposure At Default Loss Given Default 3 Probability of default Probability that the borrower will default on the loan before the loan is entirely repaid Remember that default includes: Bankruptcy Missed interest/principal payments Debt renegotiation (for firms) How to estimate the probability of default of a borrower: Credit scores for mortgages and consumer loans Accounting ratios and past relationship for small and medium firms Accounting ratios, past relationship, market measures, credit ratings for large firms 4 Exposure at default The amount outstanding in case of default It is normally the face value of the loan (plus unpaid interests) Example: Bank A extended a loan to company B with face value of 100€ with residual time to maturity of one year, that pays an annual interest of 3€. The EAD is equal to 103€ It may exceed the current amount outstanding if the borrower is granted a credit line and can increase the amount withdrawn before default occurs Example: Bank A extended a revolving credit line of $1,000 to company B. The amount drawn so far is $300. What is the exposure at default of bank A, $1,000 or $300? 5 Loss given default The amount an investor loses in case of default of the issuer Loss given default = Exposure at default – Recovery value Or alternatively: Loss given default = Exposure at default x (1 – Recovery rate) Example: Bank A gives a mortgage to a household of 100,000€. Upon default of the borrower, the bank sells the house and recovers 25,000€ => recovery rate = 25% The collateral plays a crucial role in determining the recovery rate of bank loans 6 Measuring and managing credit risk The concepts of adverse selection and moral hazard will provide our framework to understand the principles financial managers must follow Adverse selection: Those with the highest credit risk have the biggest incentives to borrow from others Moral hazard: Once a borrower has a loan, she has an incentive to engage in risky projects to produce the highest payoffs As we discussed in Session 10, financial managers have a number of tools available to assist in reducing or eliminating the asymmetric information problem 7 Screening 1. Screening: Collecting reliable information about potential borrowers to estimate their probability of default To mitigate adverse selection problems Screening has led some institutions to specialize in certain regions or industries, gaining expertise in evaluating particular firms or individuals – not desirable for the purpose of diversifying the loan portfolio 8 Credit scores in consumer loans Credit scores are used for mortgages and other consumer loans These loan applications are among the most standard of all credit applications The decision to approve or disapprove a consumer loan application depends on: the applicant’s ability and willingness to make timely interest and principal payments the value of the borrower’s collateral 9 GDS and TDS The ability to maintain mortgage payments is usually measured by GDS and TDS GDS refers to the gross debt service ratio equal to the total accommodation expenses (mortgage, lease, condominium, management fees, real estate taxes, etc.) divided by gross income acceptable threshold generally set around max. 25% to 30% TDS refers to the total debt service ratio equal to the total accommodation expenses plus all other debt service payments divided by gross income acceptable threshold generally set around max. 35% to 40% 10 GDS and TDS A mortgage loan applicant has the following data: GDS Ratio= (Annual mortgage payments + Property taxes) / Annual gross income =(($3,500*12) + $4,500) / $175,000 = 26.57% => Pass TDS Ratio = Annual total debt payments / Annual gross income = (($3,500*12) + $4,500 + $950 + $29,000) / $175,000 = 43.69% => Fail 11 Credit scores Loan officers may use more sophisticated credit scores than GDS and TDS to decide whether to approve or not a consumer loan application Other variables may affect the applicant’s willingness to make timely payments Marital status & age Payment history Previous relations with the bank & credit history Job stability Residence and stability of residence Number of credit cards All this information can be combined with GDS and TDS to determine a score Based on the score the loan officer accepts or denies the application 12 Credit scores In some countries, consumers are entitled to know their credit score for free, if they were denied a loan or credit card because of their credit score (see U.S., following the Wall Street Reform bill of 2010) In any case, U.S. residents are entitled a free copy of their annual credit report (basis for computing the credit score) – see https://www.usa.gov/credit- reports Knowing your credit score can help improve it! 13 Collateral Collateral plays a crucial role in mortgages (and some other consumer loans) Perfecting collateral is the process of ensuring that collateral used to secure a loan is free and clear to the lender should the borrower default on the loan This includes: Confirming the legal description of the property Confirming that there are no other claims against the property Confirming that no property taxes are unpaid Verifying that the purchase price is in line with the market value 14 Small and medium enterprises business lending High margins, small loan sizes Commercial & industrial loans can be for as short as a few weeks to as long as 5/10 years or more Short-term loans are used to finance working capital needs Long-term loans are used to finance fixed asset purchases Credit requests are presented formally to a credit approval officer and/or committee Loans to small firms or individual entrepreneurs normally backed up by the personal assets of the owner Loans to medium firms more focused on the business itself rather than the owner 15 Small and medium enterprises business lending Banks perform: Cash flow analyses, which provide information regarding an applicant’s expected cash receipts and disbursements Classic financial ratios analyses: Liquidity ratios Asset management ratios Debt and solvency ratios Profitability ratios Additional information collected on management and specific conditions (geographic, sector, etc.) that may affect the ability to meet the loan obligations 16 Large enterprises business lending Lending fees and spreads are smaller relative to small and mid-size corporate loans But the transactions are often large enough to make them worthwhile Banks’ relationships with large clients often center around broker, dealer, and advisor activities with lending playing a lesser role Large corporations often use: loan commitments (line of credit) bank guarantees to the company for the participation to tenders or the supply of goods and services term loans 17 Large enterprises business lending Loan officers often rely on rating agencies and market analysts to aid in their credit analysis The information available on the market for large enterprises is often sufficient to allow a good estimate of the probability of default for such firms Asymmetric information issues are much less significant than for small and medium sized enterprises 18 Credit registry Credit registry (or register) is a database typically managed by the central bank (national central bank, in case of the Eurosystem) that collects information on all debt granted to a household or a firm by the banking or financial system Collection of all debt positions Example: Company Amount Lender Type Alpha 1,000,000 Eur Bank A Term loan Alpha 2,000,000 Eur Bank B Mortgage Alpha 500,000 Eur Bank C Revolving credit line Extremely helpful for banks to judge the borrowers’ overall debt position and decide whether to grant a loan or not 19 Monitoring 2. Monitoring involves requiring certain actions, or prohibiting others, and then periodically verifying that the borrower is complying with the terms of the loan contact Financial institutions write protective covenants into loans contracts and actively manage them to ensure that borrowers are not taking risks at their expense Long-term customer relationships: past information contained in checking accounts, savings accounts, and previous loans provides valuable information to more easily determine credit worthiness 20 Other tools to mitigate credit risk 3. Loan Commitments: arrangements where the bank agrees to provide a loan up to a fixed amount, whenever the firm requests the loan (also called credit line) 4. Credit Rationing: (1) lenders will refuse to lend to some borrowers, regardless of how much interest they are willing to pay, or (2) lenders will only finance part of a project, requiring that the remaining part comes from equity financing 5. Diversification of Loan Portfolio by: (1) size of lender; (2) sector of business activity; (3) geographical area – this reduces the potential default correlation in the loan portfolio, i.e. the tendency of defaults to cluster 21 Other tools to mitigate credit risk 6. Use of Credit Derivatives Example: Bank A extended a term loan to company Alpha for 1,000,000 Eur and would like to reduce its credit risk exposure to the company Insurance company Safe trades Credit Default Swaps having company Alpha as a reference entity Bank A can buy credit protection against the risk of default of company Alpha by entering a CDS contract as a protection buyer Pros: Flexible and the borrower is not informed Cons: Limited to large borrowers for which CDS are available 22 Market risk The risk of loss on the trading portfolio arising from unexpected changes in market prices or market rates Equity risk: Associated with positions in equity markets (and derivatives) – risk of changes in stock prices Fixed-income risk: Associated with positions in fixed-income instruments (e.g. bonds, structured notes) and interest-sensitive instruments (e.g. interest-rate derivatives) – risk of changes in interest rates FX risk: Associated with foreign and cross-currency positions (and derivatives) – risk of changes in FX rates Commodity risk: Associated with positions in commodities (and derivatives) – risk of changes in commodity prices (agricultural, energy, metals) 23 Market risk Market risk is typically computed over a short time horizon of a few days Regulators require 1-day and 10-day market risk assessment (i.e. the potential losses one can incur over the next day or over the next 10 days due to market changes) Remember that market risk represents the risk of bearing losses on a position due to changes in market prices / rates… … hence, by nature, market risk is limited to the time needed to sell the position on the market (and hence, terminate the risk) This is in contrast with the long horizons associated with credit risk or interest- rate risk 24 Value-at-risk The Value-at-Risk (VaR) has become the standard approach for market risk measurement First introduced by JP Morgan in 1994 Adopted as standard measure of market risk by the Basel Accords for Market Risk in 1996 VaR is a probabilistic measure 25 Value-at-risk The first step is to define the profit & loss distribution of every position in the trading portfolio for a certain horizon (1 day or 10 days) Various probabilistic approaches The simplest is a parametric approach (Gaussian distribution) Profit & Loss (P&L) density function Losses Profits 26 Value-at-risk VaR is the loss level that will not be exceeded with a specified probability c% (i.e. it is a percentile of the loss distribution) Profit & Loss (P&L) density function 1-c% probability mass VaR Losses Profits 27 Value-at-risk “loss level that will not be exceeded with a specified probability c% ” c% is the probability level (confidence level) Must be very high: Usually 95% or 99% So that the probability that the actual loss may exceed VaR is very small (5% or 1%) Prob (L > VaR) = 1 - c 28 Value-at-risk VaR computed for each individual position Then aggregated to determine VaR of the entire trading portfolio VaR computed on a daily basis to monitor market risk exposure Market risk management: If market risk exposure too high: Resizing positions Hedging using derivatives 29 Session readings Mishkin, Eakins, Financial markets and institutions, 9th ed. Chapter 23 30 Economics of financial intermediation Session 16 – Banking regulation Mascia Bedendo Overview Asymmetric Information as a Rationale for Financial Regulation Deposit Insurance Restrictions to Bank Activities The Basel Rules Too-Big-to-Fail and Future Regulation 2 Banking regulation The financial system is one of the most heavily regulated industries in our economy Asymmetric information (moral hazard and adverse selection) explains the need for regulation in banking Adverse selection: “Good” banks need to separate themselves from “bad” banks Moral hazard: Once banks collect funding, they have an incentive to undertake high risk (and potentially high return) investments The main target of regulation have been commercial banks, given their key role in the allocation of financial resources in the economy 3 Banking regulation Banking regulation takes different forms Main types of regulation: 1. Deposit insurance schemes 2. Restrictions on activities and asset holdings 3. Capital requirements 4 Deposit insurance schemes The inability of depositors to assess the quality of a bank’s assets can lead to panic (bank runs) In the absence of protection, bank panics occur Major panics took place in the 19th century, and between 1930 and 1933 Deposit insurance was introduced in 1933 in the U.S. to protect depositors and is provided by the FDIC (Federal Deposit Insurance Corporation) Current level of individual standard insurance: $250,000 in the U.S Deposit insurance schemes proved very effective to avoid bank runs With a safety net, depositors will not flee the banking system at the first sign of trouble. Indeed, between 1934 and 1981, fewer than 15 banks failed each year in the U.S. 5 Deposit insurance schemes Up to the 1960s, only six countries had deposit insurance By the 1990s, the number topped 70 In the EU, deposit guarantee schemes insure depositors up to EUR 100,000 EU deposit guarantee schemes have been harmonized since 2014 (prior to that deposit insurance was fairly heterogeneous across EU member states) Has this spread of insurance been a good thing? Did it improve the performance of the financial system and prevent crises? It reduced bank runs but did not prevent financial crises As a matter of fact, deposit insurance creates moral hazard incentives for banks to take on greater risk 6 Restriction on activities The most famous restriction on bank activities was the Glass-Steagall Act The Glass-Steagall Act was passed by the U.S. Congress as part of the Banking Act of 1933 It prohibited commercial banks from participating in the investment banking business and vice versa The linkages between banking and investing activities were believed to have caused the 1929 market crash, and the ensuing depression Conflict of interest when banks invested in risky securities with their account- holders’ money 7 Restriction on activities Ads from the Commercial and Financial Chronicle, Jan 8, 1910: 8 Restriction on activities Up to 1933 it was very common for banks to help their customers place bonds and stocks using their depositors And, in general, to persuade clients to make investments that served the bank’s interests, but went against the individual’s interest The Glass-Steagall Act drew a distinct line between the banking industry and the investment industry, forbidding a financial institution to be both a bank and a brokerage The Glass-Steagall Act was largely repealed in 1999 by the Graham-Leach-Bliley Act (GLBA), allowing commercial banks to engage in investment banking and securities trading Only part that survived limits the type of assets banks may hold (for instance, banks may not hold common equity) 9 Restriction on activities A strict distinction between commercial and investment banking like the one regulated in the Glass-Steagall Act was never formally introduced in Europe Banks could perform both activities However, they should be kept distinct (e.g. Chinese walls in banking) and conficts of interests between different areas should be explicitly addressed The Glass-Steagall Act was never reintroduced The focus of regulation is currently on strengthening bank capital 10 Capital requirements Regulation sets minimum capital requirements that banks must meet - Basel agreements Pre-Basel agreements (before 1988): Banks were regulated using balance sheet measures such as the ratio of capital to assets Definitions and required ratios varied from country to country Enforcement of regulations varied from country to country Bank leverage increased in 1980s Off-balance sheet derivatives trading increased Basel Committee on Bank Supervision set up 11 1988 Basel Agreement Designed to address credit risk The assets-to-capital ratio must be less than 20. Assets includes off-balance sheet items that are direct credit substitutes such as letters of credit and guarantees Cooke Ratio: Capital must be at least 8% of risk-weighted amount of total assets. At least 50% of capital must be Tier 1 Types of Capital: 1. Tier 1 Capital: Common equity, non-cumulative perpetual preferred shares 2. Tier 2 Capital: Cumulative preferred stock, certain types of 99-year debentures, subordinated debt with an original life of more than 5 years 12  Risk-weighted capital A risk weight is applied to each on-balance sheet asset according to its risk (e.g. 0% to cash and government bonds; 20% to claims on OECD banks; 50% to residential mortgages; 100% to corporate loans, corporate bonds, etc.) For each off-balance sheet item we first calculate a credit equivalent amount and then apply a risk weight Risk Weighted Amount (RWA) consists of: Sum of risk weight times asset amount for on-balance sheet items Sum of risk weight times credit equivalent amount for off-balance sheet items 13 Regulatory arbitrage within Basel 1988 Consider the asset composition of the two following banks, A and B: Bank A Bank B Cash 100 100 Interbank loans (OECD) 200 200 Mortgages 1,000 1,000 Loans to A-rated firms 500 1,000 Loans to B-rated firms 1,000 500 Total assets 2,800 2,800 Which bank has the highest capital requirements under Basel 1988? Are they equally risky? 14 1996 Amendment Implemented in 1998 Requires banks to measure and hold capital for market risk for all instruments in the trading book including those off-balance sheet (this is in addition to the 1988 BIS Accord on credit risk capital) The capital requirement for market risk is proportional to the 99% 10-day Value at Risk computed on the trading book Enriched by Basel 2.5 in 2011 to include: Stressed VaR for market risk – calculated over one year period of stressed market conditions Extra capital charges for credit derivatives 15 Basel II Implemented in 2007 to address: regulatory arbitrage practices from Basel 1988 excessive bank leverage lack of (homogeneous) transparency on bank’s activities Three pillars: New minimum capital requirements for credit and operational risk Supervisory review: More thorough and uniform Market discipline: Better disclosure 16 New Capital Requirements Risk weights based on either external credit rating (standardized approach) or a bank’s own internal credit ratings (IRB approach) – now the risk weights are much finer than under Basel 1988 which only had 4 risk weights Basel II provides a formula for translating PD (probability of default), LGD (loss given default), EAD (exposure at default), and M (effective maturity) into a risk weight Risk weights under the standardized approach (reliance on credit ratings): Rating AAA to A+ to A- BBB+ to BB+ to B+ to B- Below B- Unrated AA- BBB- BB- Country 0% 20% 50% 100% 100% 150% 100% Banks 20% 50% 50% 100% 100% 150% 50% Corporates 20% 50% 100% 100% 150% 150% 100% 17 Credit risk mitigants Recognition of credit risk mitigants in Basel II Credit risk mitigants (CRMs) include: Collateral Guarantees Netting The use of credit derivatives The benefits of CRMs increase as a bank moves from the standardized approach to the IRB approach 18 Basel II and operational risk In Basel II there is a capital charge for operational risk Three alternatives: Basic Indicator (15% of annual gross income is set aside for operational risk) Standardized (different percentages for each business line which are then aggregated) Advanced Measurement Approach (AMA), which requires sophisticated simulations of operational events and potential losses 19 Pillars II and III Supervisory Review changes: Similar amount of supervision in different countries Local regulators can adjust parameters to suit local conditions Importance of early intervention stressed Market Discipline – Banks will be required to disclose: Scope and application of Basel framework Nature of capital held Regulatory capital requirements Nature of institution’s risk exposures 20 Basel III In response to the 2007-09 crisis, approved in 2010, ongoing implementation Capital Definition and Requirements Three types: Common equity Tier 1 Additional Tier 1 (contingent convertible bonds) Tier 2 (some subordinated bonds) Definitions of types of capital tightened and limits are set for each capital class Risk weights less dependent on credit ratings Extra capital buffers have been introduced to encourage banks to set aside capital and retain earnings in good times to face losses in bad times (most of these measures are discretional) and reduce procyclicality 21 Basel III Basel III has also introduced: Restrictions on leverage ratio Ratio of Tier 1 capital to total exposure (on-balance and off-balance, not risk weighted) must be greater than 3% Capital for counterparty risk arising from over the counter transactions (to be added to market risk calculation) Liquidity coverage ratio: designed to make sure that the bank can survive a 30- day period of acute stress Net stable funding ratio: A longer term measure designed to ensure that stability of funding sources is consistent with the long-term nature of the assets that have to be funded 22 Stress tests Main concern after 2007-09 financial crisis is that banks have sufficient capital to account for their risks and continue operations throughout times of economic and financial stress Stress tests have been introduced in many countries to assess the resilience of banks to a common set of adverse economic developments in order to “identify potential risks, inform supervisory decisions and increase market discipline” Annual Dodd-Frank Act Stress Tests for U.S. national banks and federal saving associations with assets of more than $10 billion – results available at https://www.federalreserve.gov/supervisionreg/dfa-stress-tests.htm European Banking Authority (EBA) Stress Tests for a sample of large European banks – results available at http://www.eba.europa.eu/risk-analysis-and-data/eu-wide-stress- testing 23 Climate stress tests Climate stress tests are being conducted to test the potential impact of climate risk on the banking sector: EU pilot exercise on climate risk: https://www.eba.europa.eu/risk-analysis-and- data/climate-risk-stress-testing-eu-banks/eu-wide-pilot-exercise-climate-risk FED: pilot climate scenario analysis: https://www.federalreserve.gov/publications/climate-scenario-analysis-exercise- results.htm 24 Too big to fail A financial institution is classified as “too big to fail” if it would pose a serious risk to the economy if it were to collapse The formal name of too big to fail is Systemically Important Financial Institutions (SIFIs) These institutions are subject to dedicated rules and supervision: Higher capital requirements Periodic stress tests Strict oversight by the regulator (Fed, ECB) List of Global SIFIs provided by the Financial Stability Board here: https://www.fsb.org/2023/11/2023-list-of-global-systemically-important-banks-g- sibs/ Unclear if these measures are sufficient or if they should be forced to split into 25smaller institutions Ongoing challenges for financial institutions From bail-out to bail-in (living wills) Bail-out when governments rescue financial institutions (typically with taxpayers’ money) Bail-in when creditors and depositors pay to rescue financial institutions (debt is cancelled) Digital and IT-related risks Competition from non-banks/neo-banks Green banking Geopolitical risks 26 Session readings Mishkin, Eakins, Financial markets and institutions, 9th ed. Chapter 18 27 Economics of financial intermediation Session 18 – SVB Mascia Bedendo Key financial indicators of SVB Table 1 in Vo and Le (2023) 2 Key performance indicators of SVB Table 2 in Vo and Le (2023) 3 Additional ALM indicators of SVB Table 4, panel B in Vo and Le (2023) - Weighted average duration of securities portfolio increased from 4 (2021) to 5.7 (2022) - Weighted average duration of AFS securities slightly increased from 3.5 (2021) to 3.6 (2022) - Weighted average duration of HTM securities increased from 4.1 (2021) to 6.2 (2022) 4 Session readings Vo, Lai Van, Le Huang T.T. (2023), “From Hero to Zero - The Case of Silicon Valley Bank”, Journal of Economics and Business, forthcoming. Available from Virtuale 5 Economics of financial intermediation Sessions 18 – Investment banking, private equity and shadow banking Mascia Bedendo Overview Investment banks Private equity firms Venture capital firms Shadow banking and financial innovation 2 Investment banks Investment banks perform a variety of crucial functions in financial markets We are going to look at 3 in detail: Underwriting Stocks and Bonds Equity Sales Mergers and Acquisitions More functions (e.g. securitization, brokerage for wealthy investors, etc.) have been provided as well Investment banks were essentially created in the U.S. by the passage of the Glass- Steagall Act. Prior to this, investment banking activities were part of large commercial banks The lines between investment banks and commercial banks again begin to blur as legal separation between investment banks and commercial banks is no longer 3 required Underwriting stocks and bonds The investment banker normally purchases the offering (stocks or bonds) from the company and then resells the offering in the market The services provided during this process include: 1. Giving Advice Explaining current market conditions to help determine which type of security (equity, debt, etc.) to offer Assisting in determining when to issue, how many, at what price (more important with IPOs than SEOs) 4 Underwriting stocks and bonds 2. Filing Documents SEC registration (filing) is required for issues greater than $1.5 million and with a maturity greater than 270 days A portion of the registration statement known as the prospectus is made available to the public Debt issues require several additional steps, including acquiring a credit rating, hire a bond counsel, etc. For equity issues, the investment banker may also arrange for the securities to appear on one of the exchanges 5 Underwriting stocks and bonds 3. Underwriting Firm commitment: The investment bank purchases the entire offering at a fixed price and then resells the offering to the market An underwriter may form an underwriting syndicate to share the underwriting risk Best Effort: An alternative to a firm commitment, the underwriter does not buy the issue, but rather makes its “best effort” to sell the entire issue Private Placement: The entire issue is sold to a small, selected group of investors. This is rarely done with equity issues 6 Equity sales Equity Sales: when a firm sells an entire division (or maybe the entire company), enlisting the aid of an investment banker The investment bank assists in: determining the value of the division or firm and finding potential buyers developing confidential financial statements for the division for prospective buyer (confidential memorandum) negotiating the terms of the sale on behalf of the seller and helping reach a definitive agreement 7 Mergers & acquisitions Investment bankers may assist both acquiring firms and potential targets (although not both in the same deal – conflict of interests!) Deal may be a hostile takeover, where the target does not wish to be acquired Investment bankers will assist in all areas, including deal specifics, lining up financing, legal issues, etc. 8 League table 9 Private equity firms These firms use funds raised from investors to buy: Private firms Public firms that are then taken private Idea: reorganize these firms and increase their value in order to: Sell them (M&A) Bring them (back) to the stock market Description of industry: 1. Most are limited partnerships 2. Source of capital includes wealthy individuals, investment banks, pension funds, and corporations 3. Investors must be willing to wait years for their returns (typically 5 years or more) 10 Leveraged buyout (LBO) If private equity firms buy companies using a significant amount of debt, the deal is called leveraged buyout (LBO) An LBO is the acquisition of a company (typically public) using a large amount of borrowed money (bonds or loans) to meet the cost of acquisition This enables private equity firms to buy much larger firms than what they could otherwise do with their equity When bonds are used, these will be rated sub-investment grade (i.e., junk bonds) The assets of the company being acquired are placed as collateral for the loans Typical target: mature companies that generate strong operating cash flows (in order to be able to cover the interest payments on the large debt) Debt to equity ratio in financing LBOs: typically 90%-10% 11 Leveraged buyout (LBO) Very popular in the 1980s Several companies targeted by LBOs went bankrupt because of excessive leverage Most LBOs are hostile takeovers LBOs market froze after the financial crisis, but large-scale LBOs began to rise during the COVID-19 pandemic Mixed evidence on the overall value creation from LBOs and private equity in general Private equity firms very active in sectors such as healthcare and education => private profit versus social welfare 12 Venture capital firms These firms provide funds for start-up companies that have significant long-term growth potential Often become very involved with firm management and provide expertise Description of industry: 1. Most are limited partnerships 2. Source of capital includes wealthy individuals, investment banks, pension funds, and corporations 3. Investors must be willing to wait years before withdrawing money Examples of venture-backed firms include Apple, Cisco Systems, Starbucks, Tesla, etc. 13 Venture capital and asymmetric information Venture capital firms reduce asymmetric information issues Banks would not be willing to lend money to start-up companies Managers of start-ups may have objectives that differ significantly from profit maximization Venture capitalists can reduce this information problem in several ways Long-term motivation Sit on the board of directors Disburse funds in stages, based on required results Invest in several firms, diversifying some risk 14 Steps of a venture capital deal 1. Fundraising Venture firm solicits commitments from potential investors 2. Investment phase Seed investing Early stage investing Later stage investing VC firms get equity shares in the company 3. Exit Usually IPO: When the start-up firm is publicly traded, VC investors sell their shares to equity investors and obtain their profit Alternatives are mergers or acquisitions 15 Financial innovation In recent years the traditional banking business of making loans that are funded by deposits has been in decline Some of this business has been replaced by the shadow banking system, in which bank lending has been replaced by lending via the securities market The term “shadow bank” was coined by economist Paul McCulley in 2007 Shadow banks perform activities similar to commercial banks They raise (that is, mostly borrow) short-term funds in the money markets and use those funds to buy assets with longer-term maturities But they are not subject to traditional bank regulation, hence they cannot borrow in an emergency from the central bank and do not have traditional depositors whose funds are covered by insurance They remain in the “shadows” 16 Shadow banks Examples include (but are not limited to): Money market mutual funds: acquire funds by selling deposit-like shares to individual investors and use the proceeds to purchase short-term money market instruments Finance companies: sell commercial paper and issue bonds/stocks to raise funds to lend to consumers and to small businesses Entities linked to the securitization process, such as: asset-backed commercial paper conduits structured investment vehicles (SIVs) or special purpose vehicles (SPVs) government-sponsored enterprises 17 The securitization process Through securitization, financial intermediaries could transfer credit risk (originated from loans, bonds, mortgages) away from their balance sheet… … reduce capital requirements in the case of banks (which are proportional to credit risk)… … and generate liquidity from otherwise illiquid assets through the sale to the SPV (and, hence, to final investors of the tranches) Problem 1: Such liquidity has been invested to provide new loans => leverage effect Problem 2: The riskiness of the underlying asset pools was severely underestimated (see subprime mortgages) 18 Financial innovation Financial innovation can be beneficial to customers in terms of: Higher yields than the ones offered by traditional banking products Lower fees/transaction costs Financial innovation can be spurred by: Changes in demand conditions from customers Changes in supply conditions Avoidance of regulation 19  Financial innovation A virtuous example of financial innovation that was spurred by changes in supply conditions (information technology) Bank credit and debit cards: Many store credit cards existed long before WWII Improved technology in the late 1960s reduced transaction costs making nationwide credit card programs profitable The success of credit cards led to the development of debit cards for direct access to checkable funds Electronic banking: Automated Banking Machines combine ATMs, the internet, and telephone technology to provide a “complete” service Virtual banks now exist where access is only possible via the internet 20  Financial innovation Electronic payments: The development of computer systems and the internet has made electronic payments of bills a cost-effective method over paper checks or money The U.S. is still far behind some European countries in the use of this technology The U.S. writes close to 10 billion checks. In Europe, however, two-thirds of transactions are electronic (in Scandinavian countries, nearly 100%) Electronic money, or stored cash, only exists in electronic form. It is accessed via a stored-value card or a smart card – see CBDC Residual concerns: Equipment to accept e-money not available in all locations Security and privacy concerns from customers 21 Session readings Mishkin, Eakins, Financial markets and institutions, 9th ed. Chapter 22 (investment banking and venture capital only) and Chapter 19 (limited to what covered in class) 22 Economics of financial intermediation Sessions 19 – Insurance companies and pension funds Mascia Bedendo Overview The insurance industry Asymmetric information in insurance Types of insurance Regulation of insurance companies Pension plans Regulation of pension plans 2 Insurance companies Insurance companies assume the risk of their clients in return for a fee, called the insurance premium Most people purchase insurance because they are risk-averse, i.e. they would rather pay a certainty equivalent (the premium) than accept a gamble If insurance did not exist, everyone would have to set aside reserves to face adverse events… … and, ultimately, those reserves may be inadequate 3 Fundamentals of insurance Although there are many types of insurance and insurance companies, there are seven basic principles all insurance companies are subject to: 1. There must be a relationship between the insured (the party covered by the insurance) and the beneficiary (the party who receives the payment if the event occurs). Further, the beneficiary must be someone who would suffer if it weren’t for the insurance 2. The insured must provide full and accurate information to the insurance company 3. The insured is not to profit as a result of insurance coverage 4 Fundamentals of insurance 4. If a third party compensates the insured/beneficiary for the loss, the insurance company’s obligation is reduced by the amount of the compensation 5. The insurance company must have a large number of insured so that the risk can be spread out among many different policies 6. The loss must be quantifiable. For example, an oil company could not buy a policy on an unexplored oil field. 7. The insurance company must be able to estimate the probability of the loss occurring (this may prove difficult for insurance on some rare catastrophic events) 5 Adverse selection in insurance Asymmetric information plays a large role in the design of insurance products The presence of adverse selection and moral hazard impacts the industry, but is fairly well understood by the insurance companies The adverse selection problem raises the issue of which policies an insurance company should accept: Those most likely to suffer a loss are most likely to apply for insurance In the extreme, insurance companies should turn down anyone who applies for an insurance policy However, insurance companies have found reasonable solutions to deal with this problem. An example from health insurance: Health insurance policies require a physical exam Preexisting conditions may be excluded from the policy 6 Moral hazard in insurance Moral hazard occurs in the insurance industry when the insured fails to take proper precautions (or takes on more risk) to avoid losses because losses are covered by the insurance policy Insurance companies use deductibles to help control this problem Deductible: The amount of any loss that must be paid by the insured before the insurance company pays anything 7 Types of insurance Insurance is classified according to which type of undesirable event is covered: Life Insurance Health Insurance Property and Casualty Insurance 8 Life insurance Life insurance is a contract between an insurer and an insured in which the insurer guarantees payment of a death benefit to named beneficiaries when the insured dies Some life insurance policies instead provide insurance against the risk of living too long and running out of retirement assets Life insurance policies come in many forms. Some of the typical policies include: 1. Term Life: The insured is covered only while the policy is in effect, usually 10– 20 years (if the insured dies afterwards, no payment is made and all premia paid are “lost”). Low premium 9 Life insurance 2. Whole Life: Similar to term life, but it allows the insured to borrow against the policies cash value. When the term of policy expires, the insured can get the cash value of the policy. Cash value is the difference between the premium and the cost of insurance and it accumulates over time in a cash value account. Whole life has higher premium than term insurance 3. Universal Life: Permanent life insurance which includes both a term life portion and a savings portion (which accumulates at a higher rate than whole life) 4. Annuities: The insured makes a fixed payment or a series of payments prior to the onset of the annuity. The annuity then pays a benefit to the insured until death. It is used to cover retirement years, not death 10 Health insurance Health insurance policies are vulnerable to the adverse selection problem - those with health problems are more likely to seek coverage Individual policies must be priced assuming adverse selection Hence the premium is typically very high Most health insurance is offered through group policies where the company pays all or part of the employee’s policy premium In some countries (e.g. U.S.), public healthcare access is limited and health insurance is essential (and often paid by employers) In Europe, public healthcare is the norm, and private insurance is less common 11 Property and casualty insurance Earliest form of insurance (it dates back to the Middle Ages) Property Insurance protects businesses and owners from the risks associated with ownership Property insurance provides protection against most risks to property, such as fire, theft and some types of damage Two types of property insurance: Named-peril policies insure against losses only from perils specifically named in the policy (typically theft, fire, explosion) Open-peril policies insure against any losses except from perils specifically named in the policy (typically earthquakes, war, terrorism, etc.) 12 Property and casualty insurance Casualty Insurance (also known as liability insurance) protects against losses that occur as a result of the insured’s interactions with others or their property «Liability insurance» as it covers the losses that the insured party would be responsible for if found legally liable Car insurance and worker’s compensation insurance are classic examples of casualty insurance Car insurance: The insured can cause an accident and the insurance company will cover the damage caused to third parties Worker’s compensation insurance covers injuries to employees on the job 13 Insurance liabilities Life insurance: Insurance liabilities are long-term and predictable (actuarial tables help predict life expectancy of the insured quite well) Health and property insurance: Insurance losses are more short-term but still fairly predictable In both cases the law of large numbers applies If many people are insured, the probability distribution of the losses will converge to a normal distribution, which is easy to model: 14 Insurance liabilities Casualty insurance: Insurance liabilities are less predictable and can have long lag times The liability claim can be filed long after the policy expires (see claims filed against manufacturers of airplanes, tobacco companies, etc.) Losses arising from property/casualty insurance can be very high (e.g. terrorism, hurrican Katrina, etc.) and send even well-capitalized insurance companies in default Reinsurance can help Reinsurance consists in the allocation of a portion of the risk to another company in exchange for a portion of the premium 15 Assets held by life insurance companies (U.S.) 16 Assets held by property/casualty insurance companies (U.S.) 17 Assets held by insurance companies (Euro area) 18 Regulation of insurance companies The insurance sector is regulated What if insurance companies default? The insured must be protected and their claims paid Regulation is typically designed to protect policyholders from losses, or expand insurance coverage in the state Regulation in the U.S.: The McCarran-Ferguson Act of 1945 explicitly exempted insurance companies from any type of federal regulation Most insurance regulations is at the state level After 2008, the federal government introduced additional regulation If an insurance company is a systemically important financial institution, capital requirements, stress tests, and bail-in rules apply 19 Regulation of insurance companies Regulation in the EU: Solvency 2 introduced in 2016 applies to life insurance, non-life insurance, and reinsurance Three main pillars: Minimum capital requirements (based on risk) Transparent governance and accurate risk management Periodic public disclosure and close supervision from regulators 20 Pension plans A pension plan is an asset pool that accumulates over an individual’s working years and is paid out during retirement years Developed as individuals began relying less on children for care during their later years Also became popular as life expectancy increased 21 Types of pension plans Defined-Benefit Pension Plan: A plan where the sponsor promises employees a specific benefit when they retire For example, Annual Retirement Payment = 2% x average of final 3 years’ income x years of service Defined-Benefit Pension Plans place a burden on the employer to properly fund the expected retirement benefit payouts Fully funded: sufficient funds are available to meet payouts Overfunded: funds exceed the expected payout Underfunded: funds are not expected to meet the required benefit payouts 22 Types of pension plans Defined-Contribution Pension Plan: A plan where a set amount is invested for retirement, but the benefit payout is uncertain The benefit payout will depend upon the earnings of the fund The burden is shifted on the employee Public Pension Plan: any pension plan set up by a government body for the general public (e.g., social security) Private Pension Plans: any pension plan set up by employers, groups, or individuals – increasingly popular given the skepticism concerning the viability of public pension plans 23 Social security pension plans Traditionally based on a “pay as you go system”, where current funding is used (partially) to pay current benefits – workers today pay benefits to retirees Projected number of workers is falling while projected number of retirees is increasing, which will cause problems in years to come if not corrected The sustainability of the social security system is hard to measure. Many factors are hard to predict, such as birth rates and the rate of immigration Although it may not fail, it is wise for workers to plan other sources for their retirement cash flows 24 Assets held by pension funds (U.S.) 25 Regulation of pension plans Private pension plans are regulated to avoid underfunding and failing pension plans that leave employees without pension payments Regulation in the U.S.: The Employee Retirement Income Security Act of 1974 set a number of standards to be followed by all pension plans (disclosure, guidelines for funding, etc.) It also established a government agency that insures pension benefits up to a limit (like deposit insurance) Pension protection act of 2006 further strengthened pension funding rules to ensure greater transparency and a stronger system Regulation in the EU: Different member states have different rules Homogeneous reporting requirements to increase transparency 26 Climate change and the insurance industry: Discussion Insurance companies have indicated climate change as one of their main challenges for the future See https://www.nytimes.com/2019/12/05/climate/california-fire-insurance- climate.html Why is climate change considered a challenge for insurance companies? What obvious measures could they take to manage the risk coming from climate change? How can regulation interfere with these measures? What tradeoff do regulators face? 27 Session readings Mishkin, Eakins, Financial markets and institutions, 9th ed. Chapter 21 28 Economics of financial intermediation Sessions 20 – The mutual fund industry Mascia Bedendo Overview Size of the mutual fund industry Mutual fund structure Investment classes Hedge funds Fees Regulation 2 Mutual funds Mutual funds pool the resources of many small investors by selling them shares and using the proceeds to buy securities Suppose you wanted to start savings for retirement, but you can only afford to invest $100 / month. How do you develop a diversified portfolio? Mutual funds are one potential answer 3 The growth of mutual funds The first mutual fund similar to the funds of today (i.e. new shares were issued when new money was invested) was introduced in Boston in 1824 The stock market crash of 1929 set the mutual fund industry back as small investors avoided stocks and distrusted mutual funds The Investment Company Act of 1940 reinvigorated the industry by requiring better disclosure of fees and investment policies Mutual funds now play an important investment role in many countries Statistics provided by the Investment Company Institute https://ici.org/ 4 Net assets of worldwide regulated open-end funds 5 Net assets of worldwide regulated open-end funds 6 Worldwide open-end funds’ share of capital markets 7 Regulated funds and households’ wealth 8 The benefits of mutual funds There are five principal benefits of mutual funds: 1. Liquidity intermediation: investors can quickly convert investments into cash 2. Denomination intermediation: investors can participate in equity and debt offerings that, individually, require more capital than they possess 3. Diversification: investors immediately realize the benefits of diversification even for small investments 4. Cost advantages: the mutual fund can negotiate lower transaction fees than would be available to the individual investor 5. Managerial expertise: many investors prefer to rely on professional money managers to select their investments (although we saw that they do not outperform the market!) 9 Mutual fund structure Investment companies usually offer a number of different types of mutual funds Investors can often move investments among these funds without penalty Mutual funds are structured as closed-end funds or open-end funds Closed-End Fund: a fixed number of nonredeemable shares are sold through an initial offering and are then traded in the OTC market Price for the shares is determined by supply and demand forces The fund cannot grow Investors cannot make withdrawals (the only way to exit is to sell the shares on the OTC market) 10 Mutual fund structure Open-End Fund: investors may buy or redeem shares at any point, the number of shares outstanding is continuously adjusted The price is determined by the net asset value (NAV) of the fund Very liquid investment (investors can withdraw at any time) The fund can grow over time Most funds are open-end 11 Calculating the net asset value (NAV) Net Asset Value (NAV) Definition: Total value of the mutual fund’s stocks, bonds, cash, and other assets minus any liabilities such as accrued fees, divided by the number of shares outstanding Stocks $20,000,000 Bonds $10,000,000 Cash $500,000 Total value of assets $30,500,000 Liabilities − $300,000 Net worth $30,200,000 Outstanding shares 10 million