Bank Management Notes PDF

lOMoARcPSD|10012740 notes entire course bank management. Bank Management (Universidad Carlos III de Madrid) Escanea para abrir en Studocu Studocu no está patrocinado ni avalado por ningún colegio o universidad. Descargado por Jorge Muñoz (jorgemunozobregon@...

lOMoARcPSD|10012740 notes entire course bank management. Bank Management (Universidad Carlos III de Madrid) Escanea para abrir en Studocu Studocu no está patrocinado ni avalado por ningún colegio o universidad. Descargado por Jorge Muñoz ([email protected])  lOMoARcPSD|10012740 BANK MANAGEMENT Descargado por Jorge Muñoz ([email protected])  lOMoARcPSD|10012740 Unit 1: Banks as financial intermediaries 1.1. Flows of funds through the financial system. 1.2. Why do Banks exist? Theory of financial intermediation. 1.3. Disintermediation. Technological change and financial innovation. 1.4. Financial entity: concept and classification. European passport. 1.1. Flows of funds through the financial system. “Financial markets perform the essential economic function of channelling funds from agents who have saved surplus funds (families, government, corporations and foreign trade) by spending less than their income to agents who have a shortage of funds because they spend more than they earn” Financial markets are so important for the economy because they allow funds to be transferred from surplus units to units who have a shortage of funds ➔ Contributing to higher production and efficiency, and they allow consumers to time their purchases better ➔ Intertemporal substitution of income. (Decisión de renunciar al consume para consumir en el futuro) Financial markets operating efficiently improve the economic welfare. Types of financial markets:  Debt and Equity Markets  Primary and Secondary Markets  Exchanges and Over-the-Counter Markets (OTC) - Exchanges: where buyers and sellers of securities meet in one central location to conduct trades - OTC: where dealers at different locations who have an inventory of securities stand ready to buy and sell securities “over the counter” to anyone who comes to them and is willing to accept their prices.  Money and Capital Markets - Money markets: only short-term debt instruments are traded - Capital markets: where intermediate-term, long-term debt and equity instruments are traded. 1.2. Financial intermediaries. Why do Banks exist? Theory of Financial Intermediation What are financial intermediaries? They are institutions that acquire funds by issuing liabilities and in turn use those funds to acquire assets by purchasing securities or making loans. Descargado por Jorge Muñoz ([email protected])  lOMoARcPSD|10012740 Capital, apart from being able to get from lenders to borrowers through financial markets (direct financing), can arrive through financial intermediaries (indirect financing). This arises in response to market failures, as they (fin. Intermediaries) reduce the possibility of these occurring. The most important market failures are those related to asymmetric information: adverse selection and moral hazard Adverse selection Adverse selection is an ex-ante asymmetric information problem, since it occurs when asymmetric information occurs before the transaction occurs. One of the parties has information relevant to the final result of the transaction, information that is unknown to the other party (Private information known to one party only). The market treats agents (good or bad) equally, which is a disadvantage for those of higher quality. The solutions are the Signalling (the informed party can signal their type, transferring the information to the other party) or Screening (the under-informed party can induce the other party to reveal their information; contract design) Moral hazard This is an ex-post asymmetric information problem, as it occurs when asymmetric information occurs after the transaction. It cannot be verified whether the action committed by one of the parties is correct or not. The solution is the incentive contracts designs. Advantages of FI:  Manage settlement (payment) system  Portfolio management  Transformation services: FIs transfer liquid liabilities (deposits) to illiquid assets (loans)  Minimize transaction costs: due to their large size and the economies of scale. The highest costs are those related to asymmetric information problems.  Long-term client relationship 1.3. Financial Disintermediation. Technological change and financial innovation1 “The process by which lenders and borrowers re-engage in direct finance. This is associated with an outflow of funds from financial intermediaries to the financial markets” Technological change and financial innovation have prompted disintermediation. These two have increased dramatically as there has been changes in supply and demand 1 https://oa.upm.es/45863/1/TFG_PABLO_PIAY_RODRIGUEZ.pdf Descargado por Jorge Muñoz ([email protected])  lOMoARcPSD|10012740 conditions as well as a growing desire to avoid increasingly restrictive / less permissive regulation.  Changes in demand conditions arise from o increasing volatility in interest rates. o Adjustable-Rate Mortgages: Mortgage loans on which the interest rate changes when a market interest rate change ↓ Interest-rate risk → Lending is more attractive. o Financial Derivatives Market: Their payoffs are derived from previously issued securities → Hedge the interest rate risk.  The main changes in supply conditions are due to technological innovation and advances in information technology such as: o Bank Credit Cards o Junk Bonds o Commercial Paper o Internationalization o Securitization  Innovation to avoid regulation such as the minimum reserve coefficient, through eurodeposits and eurodollars and restrictions on interest paid on deposits through investment funds, to see commercial, etc. 1.4. Financial entity(*): concept and classification. European passport In a strict sense, it is an institution that takes deposits and grants credit. 2 2 Los bancos son entidades financieras privadas (muchos de ellos cotizan en bolsa) y su labor principal es la concesión de préstamos y la recepción de depósitos. La actividad de las cajas de ahorro consistía en la captación de fondos y recursos y en la concesión de préstamos. No tienen ánimo de lucro y su naturaleza jurídica corresponde a la de las fundaciones. No pagan impuestos, pero, a cambio, tienen la obligación de distribuir al menos un tercio de sus beneficios a obras sociales. Esta finalidad social se canaliza a través de lo que se denomina Obra Social. Las Cooperativas de crédito son sociedades con personalidad jurídica propia. Pueden realizar las mismas operaciones que los bancos y las cajas, pero deben atender preferentemente las necesidades financieras de sus socios. Las entidades de dinero electrónico son empresas autorizadas por el Banco de España para emitir dinero electrónico que se corresponde con los fondos recibidos por parte de clientes y usuarios. El dinero se almacena en medios electrónicos o magnéticos, con el propósito de utilizarlo en operaciones de pago con terceros. El ICO participa en varios fondos destinados a financiar inversiones en sectores y actividades de especial interés para la economía española. Los Establecimientos Financieros de Crédito son entidades privadas (similares a los bancos) pero que no pueden tomar depósitos, tan sólo hacer préstamos. https://www.credimarket.com/finanzas/cuales-son-los-diferentes-tipos-de-entidades- financieras/2021/02/26/ Descargado por Jorge Muñoz ([email protected])  lOMoARcPSD|10012740 Typical activities of the sector  Take deposits  Grant credit  Services  Financial activities  Payment operations  Payment management  Warranties  Financial certificates  Wealth management In this type of entity, most of the assets are taken up by credits and the liabilities by deposits. As will be seen later, this balance can collapse in the so-called bank panics. “European passport”: The criteria established in the EU regulations provide that the authorities of any Member State cannot oppose the entities authorized in another Member State to operate in their territory, leaving the activity of each entity subject to the entire Community, basically, the control by the supervisory authority of the country of origin. Unit 2: Bank Deposits Index: 2.1. Bank Liabilities and Capital: Concept and classification (*) 2.2. The nature of the Deposit Contract and Economic Incentives 2.3. Deposit Insurance 2.3.1. The rationale for Deposit Insurance: A Historical Perspective 2.3.2. El Fondo de Garantía de Depósitos (FGD)(*) 2.3.3. Deposit Insurance and Moral Hazard 2.1. Bank Liabilities and Capital: Concept and classification (*) “Debit transactions allow banks to raise funds. These transactions can be of both types: Liabilities and Capital” Bank’s Capital As in other companies, capital includes Equity (common equity (the direct contributions of the partners or shareholders)) + Reserves (earned profits not paid as a Descargado por Jorge Muñoz ([email protected])  lOMoARcPSD|10012740 dividend to shareholders). Its function is to guarantee the solvency of the entity, due to its ability to absorb losses. In financial institutions, the effects of the solvency ratio are very important. Regulation implies that banks must satisfy a solvency ratio (BIS Capital Ratio) It guarantees a solvency level for Financial Entities. Its purpose is to reinforce the agent’s confidence in the financial system solvency and to penalize risky actions that can compromise the stability of the system. Credit Entities should maintain a minimum capital proportional to the risks undertaken. Classification:  Equity (common equity) and Reserves Capital also includes other permanent funding resources  Non-Voting Shares  Preference Shares  Subordinated Debt Non-Voting shares: - Without voting rights. - Guarantee a minimum dividend payout while keeping other ordinary shareholders’ rights. - Minimum dividend payout at least 5% of Capital paid by each non-voting share, and not less than common shares. - If there is not enough distributable profit, the non-paid part of the dividend has to be satisfied in the next three years. Preference shares: - Fixed or Floating income hybrid titles. - Considered as Capital (for regulatory purpose). - The reason is its Perpetual characteristic, that implies a long-term funding (although some issues include prepayment usually after five years). - Limit 30% of Total Capital. Subordinated Debt: Descargado por Jorge Muñoz ([email protected])  lOMoARcPSD|10012740 Subordinated debt is riskier than unsubordinated debt. Subordinated debt is any type of loan that's paid after all other corporate debts and loans are repaid, in the case of borrower default. Bank’s Liabilities  Financial Liabilities due to Central Bank  Financial Liabilities due to Credit Institutions (Interbank Market)  Customer deposits: o Demand deposits (checking account): - It is a contract under which the investor deposits money in the financial institution, and can reduce, increment or cancel the account at any moment of time. - The interest payment is usually smaller than the one in other types of accounts (due to the liquidity service associated). - The institution guarantees a first-come-first -served basis. - Services associated: Checks can be written on the account. o Demand deposits (savings account): - It is a contract under which the investor deposits money in the financial institution, and can reduce, increment or cancel the account at any moment of time. - The interest payment is usually smaller than in other types of accounts (due to the liquidity service associated). - The institution guarantees a first-come-first –served basis. - Services associated: the depositor receives a passbook (libreta) that can record transactions. - Checks are not allowed. o Time deposits: - It is a contract under which the investor deposits money in the financial institution and has the obligation to maintain the money until maturity. - There is a penalty for withdrawing before maturity. - The interest payment is higher than with demand deposits, as they are less liquid. o Linked savings account: - They incentivise savings by offering fiscal advantages as well as high returns. - The more important one is the cuenta Vivienda Descargado por Jorge Muñoz ([email protected])  lOMoARcPSD|10012740  Marketable debt securities3  Other Liability accounts 2.2 The nature of the Deposit Contract and Economic Incentives El contrato de depósitos queda definido como un contrato de deuda, con vencimiento infinitesimal, no es negociable en un mercado secundario y está sujeto a la restricción del servicio secuencial. When a bank creates a deposit, it is simply borrowing from the depositor. Therefore, it is a debt contract in which the bank has the obligation to repay the borrowed amount (a fixed amount). Its maturity is infinitesimal and can be rolled over indefinitely The depositor can withdraw at any time without penalty. Thus, a demand deposit is as liquid as currency. The key difference is that currency carries no default risk whereas an insured bank could default and not be able to satisfy withdrawal demands in full. Deposits are not traded in a secondary market, thus, no market price risk. Thus, the bank is not subject to market discipline (via price). Depositors precisely know how much they will get in the future if the bank is solvent. The dependence of your payoff on the actions of other depositors satisfies a sequential service constraint. The bank pays depositors on a “first come, first served” basis. Economic incentives These four features of the deposit contract encourage some economic behaviors between banks’ managers and depositors. Two of them generate a Moral Hazard Problems between banks’ managers and depositors (Debt-Like Nature + Nontradability). The other two features help to attenuate that problem (Infinitesimal Maturity + SSC). Demandable nature of deposits helps to keep a disciplined bank management. SSC avoids free-riding behavior of depositors. 2.3. Deposit Insurance 2.3.1. The rationale for Deposit Insurance: A Historical Perspective 3 Marketable securities are investments that can easily be bought, sold, or traded on public exchanges. The high liquidity of marketable securities makes them very popular among individual and institutional investors. These types of investments can be debt securities (bonds and bills) or equity securities (stocks). Descargado por Jorge Muñoz ([email protected])  lOMoARcPSD|10012740 An uninsured (demand) deposit contract can be quite disruptive. It can lead to overdisciplining of banks and contagion effect among banks (depositors concerned about systemic risk elements). Both problems are reduced with deposit insurance 4: When a government agency insures the bank’s deposits regardless of the bank’s financial condition. Before the existence of deposit insurance, panics were often addressed by suspending Convertibility of deposits into cash (no se puede retirar dinero) y/o Issuance of clearing-house loan certificates (Commercial Bank Clearinghouse, CBCH). These loan certificates were used by the bank instead of currency. But, there are limitations to CBCH: - Size limitation: as it grows larger, the cost of cheating by a bank is reduced, and the incentive to monitor is weakened. - Depositors can never be completely sure of the integrity of the arrangement. Federal Deposit Insurance came into existence in the U.S.A during the Great Depression (in the 1930s). El gobierno tiene absoluta credibilidad de cumplir sus obligaciones, because the Federal has virtually unlimited authority. Desde el punto de vista macroeconómico, de estabilidad oferta monetaria, evitando reducciones bruscas del Stock del dinero en casa de quiebras bancarias al reemplazar los depósitos y desincentivar los pánicos. Desde el punto de vista microeconómico, mejora el bienestar del consumidor ya que reduce los costes de supervisión de los depositantes. 2.3.2. El Fondo de Garantía de Depósitos (FGD) Es un fondo con personalidad jurídica y capacidad para resolver situaciones patrimoniales conflictivas de los bancos que entrar en crisis. La pertenencia al FGD es obligatoria para las entidades del sistema bancario nacionales. El patrimonio del FGD se nutria de aportaciones fijas anuales de las entidades aseguradoras, 2 per mil en general, hasta 2016. Desde 2017, la contribución de cada entidad se individualiza y depende del perfil de riesgo de la entidad (calidad de activos, modelo de negocio, solvencia) y del volumen de depósitos a cubrir. El FGD esta regido y administrado por una comisión de 12 personas (6 BE y 6 de entidades) 2.3.3. Deposit Insurance and Moral Hazard La existencia de un seguro de depósitos genera un problema de riesgo moral en la actuación del banco. Un seguro de depósitos es como si el banco comprara una put, opción de venta, sobre sus activos al precio de ejercicio de sus depósitos. El precio que paga por esta opción, la prima, es la aportación al ese de que era fija independiente del riesgo problema de riesgo moral. Éste se resolvió con regulación: se hizo que la aportación al SD fuera variable, dependiendo del riesgo del banco. 4 Cuando un organismo gobernamental asegura los depósitos de un banco garantiza que los depositantes recibirán su reembolso prometido independientemente de la condición del banco. Descargado por Jorge Muñoz ([email protected])  lOMoARcPSD|10012740 TOPIC 3: BANK PANICS INDEX: 3.1. Bank Runs and Panics: Theories and Empirical Evidence. 3.2. Diamond-Dybvig Model. 3.3. Adverse information and bank runs models. Descargado por Jorge Muñoz ([email protected])  lOMoARcPSD|10012740 3.1. Bank Runs and Panics: Theories and Empirical Evidence What is a bank run? Situation in which depositors (more than expected) at a single bank wish to withdraw their money from their bank. What is a banking panic? Situation in which depositors (more than expected) at many banks wish to withdraw their money from their bank and there is not enough cash. In the USA there have been 6 panics before 1865 and 7 panics during the National Banking Era (1873-1914), after this two examples to highlight are the Great Depression (1929-1933) and Subprime mortgage crisis (2007) There are two theories that explain bank panics: random bank panic models (Diamond-Dybvig) and information-induced banking panic models (Bank run caused by information specific to a bank). Gorton (1988) empirically demonstrates that bank panics are related to business cycles, so the second theory would be more accurate. 3.2. Diamond-Dybvig Model The model shows that there is a theoretical justification for financial intermediation by virtue of the transformation service performed by banks. This service leaves banks vulnerable to high cost bank panics. There is a need for regulation (deposit insurance) to avoid the costs of panics. Measures that prevent the dominated Nash equilibrium (bank panic): - The suspension of convertibility at the p level. - Deposit insurance at level C2 *> C1 * - Narrow banking: theoretical proposal (never implemented) according to which the creation of two groups of banks is proposed: “narrow” banks that can only invest in low-risk assets and that they are insured by a SD and other uninsured who can invest in any type of asset. Diamond-Dybvig model: Summary Descargado por Jorge Muñoz ([email protected])  lOMoARcPSD|10012740 3.3. Adverse information and bank runs models. Three type of individuals: - Informed depositors who withdraw if the bank invests in high risk assets (Di) and do not withdraw if low-risk assets. - Impatient depositors Not informed (liquidity-driven or impatient) who withdraw anyway in the intermediate period - Not informed (the don’t know the quality of the bank’s assets) but they observe how many depositors queue o If the queue is short, they think that there are only impatient depositors (Dimpatient) ➔ they won’t withdraw o If it’s very long, they think that there are impatients (Dimpatient) but also informed depositors (Di) that are taking their money because of the high- risk profile of the bank ➔ they will then withdraw The withdrawal length can by noisy resulting in a bank run although the bank is in a good condition. There are various kind of equilibria: - Inefficient equilibria, in which depositors don’t withdraw even if they should (negative state of nature) or they withdraw mistakenly as they shouldn’t (positive state of nature). - Efficient equilibria, in which depositors withdraw in the negative state of nature. These two theories, i.e., Diamond-Dybvig and Adverse Information, only explains bank runs at individual bank level but not banking panics  The adverse information theory can be adopted to provide explanation for banking panics.  Gorton(1988) finds empirical evidence on the relationship between bank runs and economic cycles (this supports the specific information theory). TEST QUESTIONS EXAMPLES Descargado por Jorge Muñoz ([email protected])  lOMoARcPSD|10012740 1. From a theoretical perspective, you can consider that the existence of financial disintermediation (no bank, no deposits) is due to: a. The increasing volatility of interest rates. b. Economies of scale. c. Asymmetric information. d. None of the above. Direct finance (investments in the stock market...), since there are no deposits. Savers demand other products Issue of a variable rate mortgage (asset) or issue of variable rate bonds (liability) 2. About the characteristics of the deposit agreement: a. Infinitesimal maturity and the fact that it is a debt contract creates a moral hazard problem between the bank and the depositors. b. The sequential service restriction and the fact that deposits are non-negotiable reduces moral hazard between depositors and the bank. c. The fact that deposits are debt contracts and that they are not negotiable in a secondary market creates a moral hazard problem between depositors and the bank. d. All the above answers are correct. 3. Deposit insurance: a. It reduces the problem of moral hazard (bank assumes risks), since it penalizes banks that take excessive risks. b. It reduces the problem of moral hazard (bank assumes risks), since the insurance price incorporates the risk incurred by the bank. c. The moral hazard problem worsens, because if the price (percentage of deposits) of the insurance is fixed, it does not incorporate the risk that the bank incurs. d. The moral hazard problem worsens, because deposit insurance works as if the bank sells a call option. The bank is a put buyer Considering the old scheme, it is c). Unit 4: Banking regulation INDEX: 4.1. Need for banking regulation 4.2. Instruments 4.3. Objectives of banking regulation Descargado por Jorge Muñoz ([email protected])  lOMoARcPSD|10012740 4.4. Evolution and problems of banking regulation 4.5. Banking regulation problems 4.1. Need for banking regulation Banking is traditionally subject to strong regulation, although it varies depending on the cycles it has gone through. Furthermore, banks always find (or at least try to find) loopholes to exploit. Due to the functions , essential for the society, that it performs (transformation service and reduction of transaction costs), banking is subject to market failures (already seen above): asymmetric information that can lead to banking panics and externalities for the financial system (systemic crisis) and for the real economy since a bank panic is costly in terms of real resources. For these reasons, the bank industry should be regulated. Regulation seeks to avoid market failures by giving stability to the banking system and avoiding the negative consequences of systemic crises. However, regulation has negative effects (moral hazard of deposit insurance, persistence of inefficient banks...) for this reason the principle of second-order optimum is applied. This implies that before implementing the regulation, it is necessary to carry out a careful cost-benefit analysis to determine whether it is efficient to apply said regulation. 4.2. Instruments First we find regulatory instruments of structure, they are those that control deposit insurance; the existence of a lender of last resort (in Spain the Bank of Spain); the functional separation of institutions (for example, commercial from investment, which offers stability to the banking system) or at least entry requirements such as capital (Minimum threshold on capital requirements). On the other hand, there are those of conduct (behavioural). These are, for example, the rules for publishing information, interest rates regulation, etc. 4.3. Objectives of banking regulation. The objectives of banking regulation are five: Market structure and competition Objective: Descargado por Jorge Muñoz ([email protected])  lOMoARcPSD|10012740 The aim is to reduce excess competition, which was accused of causing excessive risk taking that led to a high number of bankruptcies. For this, regulations are established that create barriers to entry and competition. These regulations limit competition and the risk assumed by entities. Cost: Less use of both economies of scale and scope or range, in addition to the fact that banks become more inefficient and there is low market discipline. As an example, in those countries such as the United States or Spain where geographic restrictions have been in force, they have been characterized by having a large number of banking institutions (fragmented banking systems), each CA had a series of medium to small-sized banks and savings banks. Instruments: - Entry restrictions are requirements for banking activity, related to the solvency or requirement of a minimum capital, good repute and competence of the managers, etc. - Restrictions on the opening of branches (although now it is the banks themselves that are closing them due to the boom in online banking), the geographic scope of action of the entities is limited by not allowing to open branches freely throughout the territory, - Mergers, for the merger of two banks, government authorization is required, which is granted based on how the merger affects competition (unfair competition and oligopolies: National Markets and Competition Commission). - Holding (restrictions on business development), the possibility of creating holding companies is limited to participate in other activities such as consulting, insurance, etc. Security and stability, The objective is to maintain the safety and soundness of the banking system and reduce the likelihood of systemic crises. Descargado por Jorge Muñoz ([email protected])  lOMoARcPSD|10012740 Mechanism and costs: - Deposit insurance: To avoid depositors withdraw their money at wrong time. Cost: Moral hazard between banks and regulators - Ceilings to interest rates on deposits, price competition is limited by reducing the cost of liabilities, which seeks to discourage investment in risky assets, ensuring that the bank's profits are higher and less volatile. Cost: it has to create competition in other variables to increase volume, which produces overinvestment in variables other than price. This implies a distorted and inefficient allocation of resources. - Regulatory supervision, it is about the periodic examination of the entities, on the part of the governmental supervision agencies and by external and internal audits. - Capital requirement (ver aparte) - Bank activity restriction consists of the legal separation between commercial banking and investment banking (in the US, Glass Steagall Act). - Limits to large risks: an entity cannot take risks whose value exceeds 25% of the PR with a client or group related to each other. Capital Requirement  Objectives: The objectives are to support the solvency and ensure the continuity of the Financial Institution (bank). These are established and regulated in the different agreements taken in Basel (I and II).  Minimum capital requirement: are minimum own resources that guarantee the continuity of the financial institution in bad moments (expected losses: provisions) and in bad moments atypically bad (unexpected losses: capital).  Regulatory capital: is the minimum capital level required by the regulator. It is a formula that allows evaluating the risks assumed by the entity and assigning them a minimum operating capital: probability of non-payment, loss in the event of non-payment, exposure at the time of non-payment, term, correlation of non-payments. Types of own resources: Tier I: It is a main Regulatory Measure of the financial solvency of a bank More “reliable” and liquid financial capital. They allow the absorption of losses and guarantee the continuity of the banking business. Within Tier I, the Core Capital is the Capital of the highest quality Tier II: is Supplemental Capital, the second most reliable source of capital from a regulatory point of view. They allow the absorption of losses but do not guarantee Descargado por Jorge Muñoz ([email protected])  lOMoARcPSD|10012740 the continuity of the banking business. To calculate the solvency ratio, the bank's assets are divided into categories, according to the level of risk (market, credit and operational) and a new risk- weighted asset (RWA) is calculated. Solvency ratios or BIS ratios require: Basel I VS Basel II: Basel II is a more sophisticated and risk-sensitive model than Basel I. Its improvements consist of bringing Regulatory Capital closer to Economic (reality of the entity). It is a model based on the quality of risks and the effectiveness of the management process. The elements are: Pillar I: Measurement and Evaluation of minimum capital requirements (Credit, market and operational risk). It offers a simple (standard) approach and a Basic and Advanced Internal Bank Models (IRB) approach. Pillar II: Banking supervision. Pillar III: Information Market Discipline. In Basel III the objectives are the promotion of Financial Stability and Sustainable Economic Growth and the strengthening of the banking sector as a result of the lessons of the crisis. The measures to be taken are to increase the quality, quantity and international consistency of capital, reinforce liquidity standards, deter excess leverage and risk taking, and reduce procyclicality and systemic risk. Impact of Capital Increase On Risk: Direct Impact: Lower risk due to higher ability to absorb losses. (-) Indirect Impact: Lower incentives from assuming risks, as shareholders and supervisors supervise managers. (-) Outsider equity effect: when the level of capital is very high, an agency problem may arise between insider managers and the shareholders not involved in the management, generating an increase in the level of risk (+ sign). Consumer protection (national consumer protection, see Contracts and TR 2007). Examples are: - Credit interest rate caps. - Regulation against usury. - Credit information requirements, credit conditions that must be public. Descargado por Jorge Muñoz ([email protected])  lOMoARcPSD|10012740 Credit allocation, - Establishing mandatory investment coefficients or - deductions and tax facilities (incentives) in credits for housing, education, social programs, etc. Monetary control, with: Legal requirement of a minimum of reserves, with a cash ratio. Lender ultimately, the Central Bank can provide liquidity to banks with discretionary problems. The banking system can have impacts, in its crises, both in the field macroeconomic and microeconomic if the regulation is restrictive. The banks develop mechanisms to exploit legal loopholes, for which the regulation passes to be even more restrictive within the 5 scopes. The effects that are achieved have both positive and negative aspects. The effects, for example, of entry restrictions for banks are: POSITIVE NEGATIVE Greater control over few entities. Oligopoly. “Risk control”, adverse selection is There is no competition. avoided. The market is not efficient. Capture of the regulator à regulation "to measure". The effects of solvency ratios are: POSITIVE NEGATIVE Solvency. There are no risks. Greater stability for the system. Slower economic growth. More stable economic growth. 4.4. Evolution and problems of banking regulation USA: It is seen from the point of view of the United States. In 1913 the Federal Reserve Act was approved, creating the Federal Reserve made up of 12 federal banks. The Fed acted as the lender of last resort. In 1927: the McFadden Act is approved, which implies geographical restrictions on the expansion of the banking business. After the Great Depression, the Glass Steagall Act is passed (1933), which creates the FDIC and establishes a separation between commercial and investment banking, to protect the market. This new regulation created interest rate limits (eliminating interest on current accounts) and placed restrictions on new competitors. As a result, there was adverse selection, because banks raised interest rates on loans and high- quality borrowers were left out of the market, even if moral hazard declined. Descargado por Jorge Muñoz ([email protected])  lOMoARcPSD|10012740 In 1935, regulation Q came into force, imposing caps on the interest rates of time deposits, creating the Federal Savings and Loans Insurance Corporation (FSLIC), deposit insurance of the S&L. In 1956 the Bank Holding Company Act was passed, followed in 1960 by the Bank Mergers Act and in 1978 by the International Banking Act. At the end of the 70s, a period of deregulation was entered. It is a period of stagnation (there is no economic growth, but there is inflation, p). In addition, it enters the Oil Crisis. In 1980, there was a deregulation of caps on deposit interest rates and an increase in deposit insurance coverage. In 1982: the deregulation of the S&L causes a crisis in Savings and Loans, for this reason in 1991 new regulations are produced: the premiums of the SD are increased, the too big to fail policy is limited and the FDIC is forced to intervene precautionary before a crisis. The Glass Steagall Act has recently been removed. Basel I (1988) conglomerated the so-called Reaganomics and the policies of Margaret Thatcher (neoliberalism) 1. In 1999, the separation of investment and commercial banking was eliminated. We enter a new period of regulation at the beginning of the 21st century with the financial crises (technology bubble, Enron, real estate bubble) that are suffered. In the United States, the Sarbanes Daxley Act (investment protection), which implements internal control and auditing, and the Dodd Frank Act in 2010, with the Volcker Rule, which prohibits the so-called proprietary trading, are passed. In addition, there are two new conferences: Basel II (2004) and Basel III (2013). Even so, deregulation persists, but only in the USA, possibly due to the force of lobbies. In Western Europe after the First World War there was a short boom during the signing of the peace treaty, but then it went into a recession in 1920-21. The general trend was the close ties between banking and industry and a universal banking model. There were differences between countries according to the relationship of the banking system to industry, the importance of the depression and the intervention policy of the central bank. As described, the regulatory system is a consequence of the financial crises of the 1930s and will prevail in the US and Europe until the 1980s. In general, there is a definition of bank and conditions for its creation, PR and minimum common capital. In addition, the liquidity and solvency ratios, as well as mergers and acquisitions, are very similar. There is a supervision of banks throughout Western Europe between this period (1930-1980). In 1957, the Treaty of Rome was signed, which establishes a trend towards deregulation and harmonization of financial services in the EU. In 1977 the first Descargado por Jorge Muñoz ([email protected])  lOMoARcPSD|10012740 Banking Coordination Directive came into force. There have been recent regulatory processes in the financial sector: 2002-2003: Codes of good governance; 2004: Circular 4/2004 BE for the application of the new International Financial Reporting Standards; 2007: Markets in Financial Instruments Directive (MiFID); 2008: Basel II; 2008: Solvency II; 2010: SEPA (common payment area in the EU). 4.5. Banking regulation problems Regulation, like deregulation, has its benefits and drawbacks (taking into account that the interests of the agents that participate in this market are normal). Information requirements create vulnerability to panics and are costly. Deposit insurance for its part creates moral hazard. The regulation of interest rates generates competition with other variables and cross subsidization (the practice of raising prices to one group to keep the prices of another low). In addition, it enters the capture of the regulator and creates a reduction in protection against mismanagement and fraud. As already mentioned, the regulation seeks to give stability to the banking system. Its main instrument is deposit insurance. The different regulations try to alleviate the moral hazard problem that is generated; a cost-benefit analysis should be carried out to determine whether it is efficient to apply said regulation. Measures to reduce moral hazard: Partial insurance: The absence of insurance can generate an overreaction to the information. Full insurance destroys depositors' incentives. The advantages are that depositors supervise better than the regulator. It also generates subordinated debt. Intervention policy: It means giving incentives to regulators to intervene in time. The advantages are that duplication of monitoring costs is avoided, but the disadvantage is that they are too lax measures to enforce. Bank Charter Values: charter values are the present value of future rents. The charter values limit the risk. They are the value that a bank can continue to do business in the future, reflected as part of its share price. Capital requirements and premiums linked to risk: Incentives are given to banks not to take too much risk. The key is the regulator's ability to observe the Descargado por Jorge Muñoz ([email protected])  lOMoARcPSD|10012740 level of risk. Portfolio restrictions: They prohibit investment in certain assets (Narrow banking). Unit 5: Analysis of credit risk. INDEX. 5.1. Bank asset: concepts and classification 5.2. Credit risk 5.3. Factors considered in the credit analysis 5.4. Long-term bank-client relationship 5.5. Credit rationing 5.1. Bank asset: concepts and classification The balance of a bank: Active operations can be classified according to their nature: Loans and credits Overdrafts in checking account Commercial discounts Advance on documents Portfolio of securities Immobilized Guarantees and other guarantees Loans and credits Loan: Money is given to another party in exchange for repayment of the loan principal amount plus interests. Lines of Credit: A borrowing limit that can be drawn on at any time. The borrower can take money out as needed until the limit is reached. There are four basic differences: Descargado por Jorge Muñoz ([email protected])  lOMoARcPSD|10012740 Quantity: - Loan: specific/fixed amount according to the contract - Credit: the lender makes money available to the client up to a limit. Expiration: - Loan: the holder must return the full amount of the loan. - Credit: will return only the outstanding balance at that time. Interests, commissions and expenses: - Loan: they are calculated at the beginning of the operation. - Credit: periodic settlements based on the average balance used. Renewal: - Loan: it must be paid within the established period and for its renewal, implement a new loan. - Credit: can be renewed one or more times at maturity. There are several forms of loan and credit: - According to their destination: consumptive and productive - According to the expiration period: short, medium, or long term - According to the borrower (recipient): public or private - According to your guarantee (collateral): personal and real - According to its instrumentation: in policy, public deed, commercial effects, etc. - According to the way of establishing the interest rate: fixed and variable rate - Based on the number of lenders: sole lender and syndicated loans Overdrafts in current account They are actually credits for which there is no formal request, in any case, verbal, which consist of a payment order against said account for an amount greater than its balance, and which is accepted by the entity based on the personal trust that the customer deserves. Commercial discount and advances The commercial discount supposes the advance of the amount (deducting the interests, commissions and expenses) of the commercial papers. Advances on documents are a variant of the previous formula, by which the entity receives the endorsement of certain documents whose amount anticipates the owner. 5.2. Credit risk Credit risk is the possibility that the debtor does not return the principal and / or interest on the credit granted by the bank. In the credit risk analysis, the bank must determine the capacity and willingness of the borrower to repay credit, for which it looks at the past history (reputation of the agent) of the borrower and its future Descargado por Jorge Muñoz ([email protected])  lOMoARcPSD|10012740 economic prospects. 5.3. Factors considered in the credit analysis The main problems in the relationship between lender (bank) and borrower (company) are related to asymmetric information: - Before signing the loan: the bank does not know the credit quality of potential borrowers, so it cannot set a price (interest rate) for high-quality loans and another for low-quality ones. It then sets an average interest rate that can drive the most reliable out of the market (Adverse Selection). Collateral and equity can help signal the quality of the borrower and allow the design of contract menus. - After the loan is signed: the bank cannot control that the borrower dedicates all his effort to the success of the financed project (moral hazard). Guarantee, equity, relationships to LP can help design incentive contracts that align the interests of bank and borrower. The borrower's probability of repayment depends on: Capacity: It ensures that the borrower has the legal and economic capacity to borrow. The borrower's legal and financial capacity to borrow is analyzed - Legal capacity of the person requesting it: Is the applicant legally entitled or authorized? - Financial capacity: analysis of future cash flows that the company will use to pay the debt. Character (commitment to the project): The bank analyses the possibility and the desire of the borrower to repay the loan and to fulfil all the obligations within the terms of the contract. In addition, it conducts an examination of the borrower's past history in the repayment of other debts, the past history (reputation) of the borrower provides us with information about his future behaviour. The better reputation a borrower has, the less is his incentive to lose that reputation and default on credit. Finally, a good reputation is acquired, allowing you to pay lower interest rates. The better the reputation, the future rates will be lower and lower, which is why it will tend to preserve that good reputation. Firm Capital: Resolution of private information and moral hazard problems. Capital is a solution to reduce information asymmetry problems - Capital as a signal sent by the company owners who trust on the success of the project. Descargado por Jorge Muñoz ([email protected])  lOMoARcPSD|10012740 - Capital as a way to mitigate moral hazard as the company contributes with its own resources, thus borrowers and lenders’ incentive are aligned. EXAMPLES: Exercise on Thursday Guarantee (Collateral) ◃ Risk reduction as it can lower loss in case of default ◃ Information asymmetry problems are mitigated: ⋄ Collateral as signal: a guarantee implies a high quality borrower, who can afford to lose it in case of default ⋄ Collateral as a way to mitigate moral hazard: a guarantee contributed to the alignment of the lender and borrowers’ interests, which mitigate asset substitution and inadequate effort. ◃ The execution of a Collateral implies additional costs for the bank (liquidation, valuation, legal,...) ◃ Examples: In practical session: Resolves moral hazard and reduces the Bank's Risk. Risk is reduced by reducing loss in case of failure and asymmetric information problems are solved with: - Guarantee as a signal: in the event of an adverse information problem, the guarantee reveals the high quality of the borrower by being willing to compromise a guarantee that in the event of non- payment will be delivered to the bank. - Guarantee solves the problem of moral hazard: the guarantee allows aligning the interests of the borrower with those of the bank since they have an interest in the success of the project to prevent the bank from keeping the guarantee. Solve problems: asset substitution and improper effort. Using guarantees has a cost for the bank (settlement, value estimation, legal,...). Capital solves asymmetric information problems: - Capital as a signal sent by the owners of the company about their confidence in the success of the project. - Capital solves the problem of moral hazard the company contributes its own money and the incentives of the company are aligned with the bank. Terms: Economic conditions that affect the ability of the borrower to repay the loan. 5.4. Long-term bank-client relationship Long-term relationships are generally beneficial. They reduce moral hazard problems Descargado por Jorge Muñoz ([email protected])  lOMoARcPSD|10012740 since if a borrower knows that he will need to borrow in the future, he will limit actions that represent losses for the bank today. In addition, the relationship to LP allows banks to learn from borrowers over time, since it allows them to have private information about their borrower. The more positive information that the borrower accumulates, the better the conditions that the bank offers in its credits. 5.5. Credit rationing Credit rationing occurs in two ways (stiglitz & weiss): The first occurs when the bank refuses to grant a loan at any interest, even when the borrower is interested in paying higher interest. It occurs as a consequence of the fact that the problem of adverse selection is accentuated as the bank increases the interest. The riskiest borrowers are the most likely to go to market. There is an excess demand for credit. In a world of asymmetric information, credit rationing is an optimal strategy for a bank that maximizes profit. The bank does not want to increase the interest rate (i) to (i *) since it would aggravate the problems of Adverse Selection and concludes with the interest rate at which the expected profit maximizes is the one for which the demand exceeds the supply The second form of credit rationing occurs when the bank restricts the size of the loan more than the borrower would like. It allows banks to fight against the problem of moral hazard, since the greater the volume of the loan, the greater the incentives to undertake risky acts. Descargado por Jorge Muñoz ([email protected])  lOMoARcPSD|10012740 Descargado por Jorge Muñoz ([email protected])  lOMoARcPSD|10012740 Unit 6: Interest rate risk INDEX: 6.1. Fixed Income Securities 6.2. Interest rate risk concept 6.2. Measure of the accounting gap 6.3. Measure of duration 6.1. Fixed Income Securities Concepts of Fixed Income Securities ◃ Bond ◃ Bond Price ◃ Yield to maturity ◃ Zero coupon bond ◃ Term structure of interest rates Elements of Fixed Income Securities  Face value: Principal amount of the loan (or security) used to calculate the future regular payments (coupons).  Coupon: the interests payments paid at regular intervals (month, quarter, year, etc) which are set at the time of the issue  Maturity date: Time in the future at which the loan (or security) ceases to exist and the principal repayment takes place.  Principal repayment (amortization): Repayment of the principal at the maturity date. How to Construct the Term Structure of Interest Rates ◃ SPOT interest rate for time period [0,t]: The internal rate of return of a bond with the highest quality whose repayment takes place at t. ◃ It is denominated ◃ can be obtained using the market prices of strips (stripped bonds), which was issued at t = 0 and will mature at t Valuation of Bond with Constant Coupon Descargado por Jorge Muñoz ([email protected])  lOMoARcPSD|10012740 Assume that a fixed income security pays regularly at each period (at t = 1,2,3,...,n) a coupon that is equal to C and the bond is repaid at pay. The cash flow are represented as follows: IRR (Yield to Maturity) IRR or yield maturity: measures the return obtained by someone that buys the bond today and holds it up to maturity. 6.2. Interest rate risk concept The interest rate risk is the probability of future loss derived from an adverse evolution of interest rates 6.3. Measure of duration The duration is the average of the terms of the cash flows weighted by the percentage that its present value represents in the total present value. It allows to distinguish between maturity time and average life of an asset or liability. It is a measure of the temporal characteristics of a bond and is expressed in units of time. Duration allows: Measure the temporal characteristics of a bond. Model the sensitivity of the price of bonds to changes in interest rates. Descargado por Jorge Muñoz ([email protected])  lOMoARcPSD|10012740 Build “immunized” fixed income portfolios, the performance of which is independent of the evolution of interest rates. Duration: Average duration: Sensitivity of the price of an asset to variations of 3: The longer the duration, the greater the variation in the price due to changes in interest rates. To immunize a fixed income position / portfolio, the time horizon must be equal to the bond duration (Debt duration = Investment duration). 6.4. Measurement of the accounting gap. GAP in a horizon t is defined as the difference between variable or sensitive assets and variable or sensitive liabilities in that horizon. Sensitive assets (liabilities) are those that must be renewed at market interest rates within the considered horizon. GAP (t) = AS (T) - PS (t) Δ Profit (t) = GAP (t) ∗ Δr (T) - If GAP (T) = 0: variation of r does not affect Profit. - If GAP (T)> 0: increase in r increases Profit. - If GAP (T)