FM 563 Summary PDF

FM 563 SUMMARY Formulas: Unit 2 : Bank Performance and Ratios 1. Capital Adequacy Ratio (CAR) (𝑻𝒊𝒆𝒓 𝟏 𝑪𝒂𝒑𝒊𝒕𝒂𝒍 + 𝑻𝒊𝒆𝒓 𝟐 𝑪𝒂𝒑𝒊𝒕𝒂𝒍 ) 𝑪𝑨𝑹 = 𝑻𝒐𝒕𝒂𝒍 𝑹𝒊𝒔𝒌 𝑾𝒆𝒊𝒈𝒉𝒕𝒆𝒅 𝑨𝒔𝒔𝒆𝒕𝒔 Tier 1 Capital = Gross Core Capital – De...

FM 563 SUMMARY Formulas: Unit 2 : Bank Performance and Ratios 1. Capital Adequacy Ratio (CAR) (𝑻𝒊𝒆𝒓 𝟏 𝑪𝒂𝒑𝒊𝒕𝒂𝒍 + 𝑻𝒊𝒆𝒓 𝟐 𝑪𝒂𝒑𝒊𝒕𝒂𝒍 ) 𝑪𝑨𝑹 = 𝑻𝒐𝒕𝒂𝒍 𝑹𝒊𝒔𝒌 𝑾𝒆𝒊𝒈𝒉𝒕𝒆𝒅 𝑨𝒔𝒔𝒆𝒕𝒔 Tier 1 Capital = Gross Core Capital – Deductions Tier 2 Capital = Gross Core Capital – Deductions Total Risk Weighted Assets = Capital Risk + Market Risk + Operational Risk 2. Return on Assets (ROA) 𝑁𝑒𝑡 𝐼𝑛𝑐𝑜𝑚𝑒 Return on Assets (ROA) = 𝐴𝑣𝑒𝑟𝑎𝑔𝑒 𝑇𝑜𝑡𝑎𝑙 𝐴𝑠𝑠𝑒𝑡𝑠 3. Return on Equity (ROE) 𝑁𝑒𝑡 𝐼𝑛𝑐𝑜𝑚𝑒 Return on Equity (ROE) = 𝐴𝑣𝑒𝑟𝑎𝑔𝑒 𝑇𝑜𝑡𝑎𝑙 𝐸𝑞𝑢𝑖𝑡𝑦 4. Loan-to-Deposit Ratio 𝑇𝑜𝑡𝑎𝑙 𝐿𝑜𝑎𝑛𝑠 Loans-to-Deposits Ratio = 𝑇𝑜𝑡𝑎𝑙 𝐷𝑒𝑝𝑜𝑠𝑖𝑡 5. Debt-to-Asset Ratio 𝑇𝑜𝑡𝑎𝑙 𝐷𝑒𝑏𝑡𝑠 Debts-to-Assets Ratio = 𝑇𝑜𝑡𝑎𝑙 𝐴𝑠𝑠𝑒𝑡𝑠 Unit 3: Mortgage Markets 𝑃 𝑥 𝑖 𝑥 (1 + 𝑖)𝑡 𝑥 𝑛 𝑇𝑜𝑡𝑎𝑙 𝑃𝑒𝑟𝑖𝑜𝑑𝑖𝑐 𝑅𝑒𝑝𝑎𝑦𝑚𝑒𝑛𝑡 = (1 + 𝑖)𝑡 𝑥 𝑛 − 1 𝐼𝑛𝑡𝑒𝑟𝑒𝑠𝑡 𝑃𝑎𝑦𝑚𝑒𝑛𝑡 = 𝑃 𝑥 𝑟 𝑥 𝑡 𝑜𝑟 𝑃 𝑥 𝑖 𝑟𝑎𝑡𝑒 𝑝𝑒𝑟 𝑎𝑛𝑛𝑢𝑚 𝑖= 𝑛𝑜. 𝑜𝑓 𝑝𝑎𝑦𝑚𝑒𝑛𝑡 𝑝𝑒𝑟𝑖𝑜𝑑 𝑝𝑒𝑟 𝑦𝑒𝑎𝑟 𝑃𝑟𝑖𝑛𝑐𝑖𝑝𝑎𝑙 𝑅𝑒𝑝𝑎𝑦𝑚𝑒𝑛𝑡 = 𝑇𝑜𝑡𝑎𝑙 𝑅𝑒𝑝𝑎𝑦𝑚𝑒𝑛𝑡 − 𝐼𝑛𝑡𝑒𝑟𝑒𝑠𝑡 𝑃𝑎𝑦𝑚𝑒𝑛𝑡 1.1 Introduction to Banking BANKS – a financial institution engaged in the lending of funds obtained from deposits. Classification of Banks in the Philippines 1. Universal Banks 2. Commercial Banks 3. Thrift/Savings Bank 4. Rural Bank 5. Cooperative Bank 6. Islamic Bank 7. Digital Banks Universal vs. Commercial Banks 1.2 Financial Markets Through Time The Panic of 1907 National Banking Era (1863-1913): The U.S. did not have a central bank. Almost all commercial banks were “local” and regulated on a state level. Triggered by wild speculation in the stock market; loose lending by banks (A lack of effective oversight of financial markets). J. Pierpont Morgan - ended the panic of 1907 F Augustus Heinze -trying to “corner a market” which means buying up as much of an asset to control the price. Problem: Lack of central bank in United States. Solution: Federal Reserves was created and passed by Congress in 1913 through Federal Reserves Act. Financial Markets during Great Depression September 3, 1929 – stock market hits an all-time high Roger Babson: “Sooner or later a crash is coming, and it may be terrific”- Stock speculators receive margin calls. Stock bought on credit was falling, cash would be needed or face the loss of the stocks held. Margin calls were not being met and thus forcing to sell their shares. Markets react to lower prices causing markets selling in a near panic. Panic selling had set in. Action by business firms: They cut prices to stimulate sales; when this was not successful, they stopped borrowing from banks. 1.3 Banks and Money Asymmetric Information o Information that is not equal or even. o Can lead to inefficient outcomes. o Scarce resources of society can be waster or misallocated. Adverse Selection o BEFORE a financial transaction takes place. o A situation where undesirable results occur because the two parties in a transaction, the buyer and seller, have different amounts of information. o Difficulty in information. Moral Hazard o AFTER a financial transaction takes place.  o One entity takes on an excessive amount of risk because it knows another entity will bear the burden of those risks. o Difficulty in monitoring. Liquidity: the ease and expense at which one asset can be converted into another asset. Liquidity mismatch: A situation in which there is a lack of unity between the contractual amounts and dates of cash inflows and outflows. Principle–agent problem: The problem of motivating one party (the agent) who has been hired by another party (the principle) to act in the best interests of the hiring party. It is when banks lend money that money is created, and it is through the banking system that the money supply is decreased. Banks play an important role in the creation and reduction of the money supply. Reserve Requirement: all banks in the Philippines shall be required to maintain reserves against their deposit liabilities. Required reserve ratio: The proportion of deposits banks must hold in the form of cash or reserves. Total reserves = Required reserves + Excess reserves Primary Reserves – composed of non-earning assets such as cash in vaults, deposits with central bank (legal reserves), deposits with other banks, exchanges or the clearing house and checks for collection. If the reported legal reserve is below the required minimum, the bank shall pay BSP one-tenth of one percent (1/10 of 1%) per day. Credit crunch: A reduction in the general availability of credit most often seen as an irrational increase in risk aversion. 1.4. Philippine Banking Laws 1. New Central Bank Act (RA 7653, 1993 as amended by RA 11211, 2019) Bangko Sentral ng Pilipinas – central monetary authority of the Philippines; an independent government-owned corporation which aims to maintain price stability conducive to a balanced and sustainable growth of the economy and employment. Monetary vs. Fiscal Policy o Monetary Policy – actions and decisions made by the central bank. (money supply, interest rates and credit) o Fiscal Policy – actions and decisions made by the government. (taxation and government spending)  Monetary Board o Composed of 7 members appointed by the President of the Philippines for a term of 6 years. ▪ BSP Governor – Chairman of the Board ▪ Cabinet member – designated by the president; representative of the government. (At present: Department of Finance secretary) ▪ Five full-time members from the private sector. Capital of of BSP: Php 200 Billion. (as amended in RA 11211). 2. Secrecy of Bank Deposits (RA 1405) – Section 2 All deposits of whatever nature with banks or banking institutions in the Philippines including investments in bonds issued by the Government of the Philippines, its political subdivisions and its instrumentalities, are hereby considered as of an absolutely confidential nature and may not be examined, inquired or looked into by any person, government official, bureau or office, except upon written permission of the depositor, or in cases of impeachment, or upon order of a competent court in cases of bribery or dereliction of duty of public officials, or in cases where the money deposited or invested is the subject matter of the litigation. 3. Anti-Money Laundering Act of 2001 (RA 9160) Money Laundering – a crime whereby the proceeds of an unlawful activity as defined in the AMLA are transacted or attempted to be transacted to make them appear to have originated from legitimate sources. 3 Stages of Money Laundering: Placement, Layering, and Integration 4. Truth in Lending Act (RA 3765) “An Act to Require the Disclosure of Finance Charges in Connection with Extensions of Credit” This act protects citizens from a lack of awareness of the true cost of credit to the user by assuring a full disclosure of such cost with a view of preventing the uninformed use of credit to the detriment of the national economy 5. Batas Pambansa Bilang 22 (BP 22), also known as the Anti-Bouncing Checks Law, is the primary legislation in the Philippines that addresses the issuance of checks without sufficient funds. Criminal offense: Issuing a check without sufficient funds or credit to cover the amount is considered a criminal offense. Purpose of the law: The law aims to protect the public from financial loss due to bounced checks and to deter individuals from issuing checks without sufficient funds. Returned Checks A returned check, also known as a bounced check, is a check that is dishonored by the bank due to insufficient funds or other reasons. There are several types of returned checks, each with its own specific reason for being returned. Common Types of Returned Checks 1. Drawn Against Insufficient Funds (DAIF) This is the most common reason for a check to be returned. It occurs when the account holder does not have enough money in their account to cover the check amount. 2. Drawn Against Uncollected Deposits (DAUD) This happens when the account holder writes a check for an amount greater than the available balance, even if there are outstanding deposits that have not yet cleared. In essence, the funds from the deposited checks are not yet accessible for withdrawal. 3. Post-Dated Check A post-dated check is written with a future date. Banks typically return post-dated checks because they are not valid until the specified date. 4. Stale Check A stale check is an old check that has been outstanding for an extended period (usually six months or more). Banks may return stale checks due to potential security risks or changes in account information. Other Possible Reasons for Returned Checks Account Closed: The account on which the check was drawn has been closed. Stop Payment Order: The account holder has placed a stop payment order on the check. Signature Mismatch: The signature on the check does not match the signature on file at the bank. Material/Check Alteration: The check has been altered, making it invalid. Unit 2: Banking Management, Operations and Regulations A) Banking Management and Operations Deposit Substitute: alternative form of obtaining funds from public, other than deposits, through the issuance, endorsement or acceptance of debt instruments for the borrower’s own account, for the purpose of re-lending or purchasing receivables and other obligations. Instruments: o Banker’s acceptance – negotiable time drafts guaranteed by the accepting bank, payable at maturity and drawn by creditor against a debtor. o Promissory note – a debt instrument that contains a written promise by one party to pay another party a definite sum of money, either on-demand or a specified future date. o Participations – represents the portion of the share of securities allotted to each member of a distributing syndicate, known as a participant. o Repurchase agreement – an agreement to repurchase the securities at a higher price on a later date.  ACCOUNT OWNERSHIP o Individual or Single account is an account maintained solely by a depositor (natural person or juridical entity/organization) ▪ In Trust For (ITF) ▪ By o Joint account is an account held jointly by two or more natural persons, or by two or more juridical persons or entities. ▪ Conjunction “AND” – depositors shall only be allowed to withdraw from the said account with the authority of ALL depositors named in the account. ▪ Conjunction “OR” – ANY of the depositors of joint accounts may be allowed to withdraw from the said account, even without the authority of other depositors named in the account. B) US Banking Regulations 1. Regulation Q (Banking Act of 1933) – forbade banks to pay interest on checking accounts or demand deposits. 2. Emergency Economic Stabilization Act of 2008 – Federal Deposit Insurance Corporation (FDIC) deposit insurance was increased from $100K to $250K per account per institution. 3. Glass-Stegall Act of 1933 - separated commercial banking, investment banking and the insurance industry. 4. Gramm-Leach-Bliley Act (or Financial Modernization Act) - allowed bank holding companies to morph into “financial services holding companies”. 5. McFadden Act of 1927 - forced federally chartered banks to obey state laws when it came to branching; essentially making it impossible for banks to cross state lines. 6. Riegle-Neal Interstate Banking Act (1994) - allowed banks to merge across state lines, thus enabling them to have branches in other states. 7. Truth in Lending Act of 1968 - designed to ensure that every borrower understands what they are getting themselves into when they agree to borrow money; requires full disclosure of the terms and costs involved in the loan. 8. Community Redlining Act (CRA) of 1977 – banks to seek CRA certification if they want to merge, expand their branches, or seek to undertake any action that requires regulatory approval. o Redlining - the act of denying financial services to people living in a particular area. 9. Fair Credit Reporting of 1970 - designed to regulate the collections and use of consumer credit information and to require creditors in providing complete and accurate information to credit bureaus or face penalties. 10. Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010 - increases amount of consumer protection in financial markets; limits unfair or  abusive lending practices, enforces federal consumer protection laws, outlaws discrimination and other unfair treatment in consumer finance. REGULATORY SYTEM: POLICIES, RISKS and FAILURES. 1. Pay off and liquidate: policy used by regulators to deal with failed or failing institutions. 2. Purchase and Assume: the regulator finds a healthy bank to purchase the failed institution and assume all of the failed bank’s liabilities. 3. Too big to fail (TBTF): a policy followed by bank regulators whereby some financial institutions are important to the entire financial and economic system that these institutions will not be allowed to fail. Regulators will take action to ensure that these systemically important institutions continue in operation. 4. Systemic risk : threat that the failure of one entity can lead to a failure of the entire banking, financial, or economic system. 5. Regulator shopping: refers to banks and other financial institutions allowed to choose their regulator – they may pit the regulators against each other and then choose the regulator that offers the most favorable regulations. 6. Intellectual Capture: a widely held belief that whatever benefits the financial industry must also be beneficial to all of society. C) PH Banking Regulations D) Banking Trends BSP on Financial Inclusion Financial inclusion is a state wherein there is effective access to a wide range of financial services for all, especially the vulnerable sectors. BSP on ESG (Environmental, Social and Governance) BSP Circular 1149, Series 2022: Guidelines on the Integration of Sustainability Principles in Investment Activities of Banks o ESG Strategies: ▪ Integration – an approach which involves an explicit and systematic inclusion on material environmental and social factors in investment analysis and decisions to better manage risks and improve returns. ▪ Screening - an approach which involves the application of filters to lists of potential investments to rule companies in or out of contention for investment. ▪ Thematic Approach – refers to investing based on trends such as social, industrial and demographic trends. BSP on Financial Technology (FinTech) and Artificial Intelligence (AI) ❑ Aligning the country’s financial regulations and policies with international standards to improve risk management and ensure competitiveness in view of Association of Southeast Asian Nations’ integration. ❑ Strengthening anti-money laundering capability and risk management systems to address weaknesses exposed by financial controversies. ❑ Promoting financial inclusion and access to financial services by the poor. ❑ Addressing risks arising out of new technology while at the same time encouraging innovation. Unit 3: Mortgage Markets A) Basic Mortgage Concepts Down Payment – the amount of the purchase price a buyer must provide out of his or her own financial resources; Required down payment: 20% cash, 80% financing Private Mortgage Insurance (PMI) - The amount of the purchase price a buyer must provide out of his or her own financial resources; insures the lender against a major loss in the case of default by the borrower. If 20% is not met, borrower may have to seek private mortgage insurance (PMI). Fixed-Rate - a loan where real estate is used as collateral and the interest rate paid by the borrower does not change over the life of the loan; the borrower will have a good idea of their future payments. Adjustable-Rate Mortgages – a loan where real estate is used as collateral and the interest rate paid by the borrower may be changed by the lender under terms stated in the loan; interest rate adjustment are based on published index (1-year  Treasury Bills yield, London Interbank Offer Rate (LIBOR) and Cost of Fund Index (COFI); shifts the interest rate risk from lender to borrower. Insured Mortgages - borrowers may get a lower interest rate on loans if the mortgage is federally insured; guaranteed by either government or government- controlled entities. Conventional Mortgages - requires the borrower to obtain Private Mortgage Insurance (PMI) loans; not guaranteed by government or government-controlled entities. Discount Points - interest payments made at the beginning of the mortgage. Mortgage Payments: Amortization o The settlement of loan, including principal and interest made by equal payment and over a specified period of time. 𝑃 𝑥 𝑖 𝑥 (1+𝑖)𝑡 𝑥 𝑛 o 𝑇𝑜𝑡𝑎𝑙 𝑃𝑒𝑟𝑖𝑜𝑑𝑖𝑐 𝑅𝑒𝑝𝑎𝑦𝑚𝑒𝑛𝑡 = (1+𝑖)𝑡 𝑥 𝑛 −1 o 𝐼𝑛𝑡𝑒𝑟𝑒𝑠𝑡 𝑃𝑎𝑦𝑚𝑒𝑛𝑡 = 𝑃 𝑥 𝑟 𝑥 𝑡 𝑜𝑟 𝑃 𝑥 𝑖 𝑟𝑎𝑡𝑒 𝑝𝑒𝑟 𝑎𝑛𝑛𝑢𝑚 o 𝑖 = 𝑛𝑜.𝑜𝑓 𝑝𝑎𝑦𝑚𝑒𝑛𝑡 𝑝𝑒𝑟𝑖𝑜𝑑 𝑝𝑒𝑟 𝑦𝑒𝑎𝑟 o 𝑃𝑟𝑖𝑛𝑐𝑖𝑝𝑎𝑙 𝑅𝑒𝑝𝑎𝑦𝑚𝑒𝑛𝑡 = 𝑇𝑜𝑡𝑎𝑙 𝑅𝑒𝑝𝑎𝑦𝑚𝑒𝑛𝑡 − 𝐼𝑛𝑡𝑒𝑟𝑒𝑠𝑡 𝑃𝑎𝑦𝑚𝑒𝑛𝑡 15-Year vs. 30-Year Mortgage o 15-year mortgage: higher monthly payments; lower interest rate. o 30-year mortgage: lower monthly payments; higher overall interest costs. Taxes and Insurance o Concept of Escrow - In addition to interest and principal, most people save for property taxes and homeowner’s insurance each month by which part of the monthly mortgage payment is the “escrow.” B) Types of Mortgages Zero Down Home Mortgage – the lender provides 100% of the purchase price of the house. Teaser-Rate ARMs - traditionally have lower initial interest rates than do fixed- rate mortgages; the borrower bears the risk that interest rates may increase in the future. Negative Amortization Home Mortgages (NegAms) - the monthly mortgage payment paid by the borrower is less than the interest charged over the month; mortgage balance increases at the end of the month. No Documentation Home Mortgage - no supporting documents; more on declaration by the borrower to lender that they can repay the loan; granted to individuals who don’t have source of income. C) Problems in Secondary Markets Mortgages were usually too small for institutional investors to purchase. Mortgages were not standardized; they mature at different times, have different interest rates, and different terms. (vs. government bonds which is standardized) Mortgages are difficult for an institutional investor to analyze and examine the default risk of every mortgagor/borrower. D) US Mortgage Markets Federal National Mortgage Association (Fannie Mae) o Publicly owned government-sponsored enterprise established in 1938 by Congress during the Great Depression as part of the new deal. o Formed to stimulate the housing market by creating additional mortgages available to moderate-to-low income borrowers. o Guarantees in the secondary market rather than providing loans. o Helped increase number of lenders; lenders are no longer need to rely on personal or private funding for home mortgage loans. Government National Mortgage Association (Ginnie Mae) o A federal government corporation that secures the principal and interest payments on mortgage-backed securities issued by approved lenders. o Guarantees timely payment on principal and interest on FHA loans and mortgage-backed securities (MBS). Federal Home Loan Mortgage Corporation (Freddie Mac) o Publicly owned government-sponsored enterprise created in 1970 by Congress to keep money flowing to mortgage lenders to support homeownership and rental housing for middle-income citizens. E) Other Concepts in Mortgage Market Mortgage-Backed Assets: Modern Pass-Throughs Also called participation certificates. Oldest and most basic form of mortgage-backed assets. Curtailment or Prepayment risk : risk that a borrower will make additional principal payments on the loan and reduce the total amount of interest paid. The borrower will repay the loan in its entirety before maturity and limit the amount of interest paid. Mortgage-Backed Assets: CMOs and CDOs Lenders pool mortgages together and the pool is cut up into different slices. French word for slice: tranche. (slices of mortgage pools).  Slices or tranches of nonmortgage loans are called collateralized debt obligations. Growth of CMO and CDO Market SECURITIZATION – the process of transforming illiquid financial assets into marketable capital market instruments. Lenders pool mortgages together and pool is cut up into different slices or tranches. Collateralized Debt Obligations (CDOs) – slices or tranches of nonmortgage loans. Mortgage Market, Government Policies and Global Financial Crisis Gaussian Copula Model – simplest way to measure correlation and price CDOs and CMOs. Copulas (Latin for “coupling”) – transform the probability of default of different assets. Securitized mortgage – low-risk securities that have higher yield than government bonds. Adding to the pressures resulting in the global financial crisis: ❑ Subprime mortgage loans – loans that are made to borrowers who do not have enough credit rating, income or collateral to qualify for a traditional mortgage; a home mortgage where the borrower has substandard qualifications. ❑ Lax underwriting standards ❑ Misalignment of incentives