Total Assets = uses to which they are put
Total Liabilities + Capital
= sources of bank funds
A bank's ___________ shows that
total assets equal total liabilities plus equity capital
balance sheet
The Bank Balance Sheet:
Liabilities
_________________ are reported as liabilities on a bank's balance sheet.
Checkable Deposits
___________ earning checking accounts-DDAs (demand deposit accounts)
Non-interest
___________ earning negotiable orders of withdrawal (NOW) accounts,
Interest
CDs or certificates of deposit
time deposits
Borrowing from the Federal Reserve System, other banks, and corporations
Examples:
discount loans/advances (from the Fed)
fed funds (from other banks)
interbank offshore dollar deposits (from other banks)
repurchase agreements (a.k.a., "repos" from other banks and companies),
commercial paper and notes (from companies and institutional
Bank Capital:
is the source of funds supplied by the bank owners,
either directly through purchase of ownership shares
or indirectly through retention of earnings.
capital is also called the balance sheet's
shock absorber," thus capital
levels are important).
Reserves and Cash Items (account for 2% of assets)
Reserves:
(very liquid)
funds held in account with the Fed (vault cash as well).
Total Reserves = Required reserves represent + excess reserves.
Cash items in Process of Collection:
(liquid)
checks deposited at a bank, but where the funds have not yet been
transferred from the other bank.
Deposits at Other Banks:
(liquid)
usually deposits from small banks at larger banks
(referred to as correspondent banking
Securities (about 17% of assets)
U.S. government/agency debt
municipal debt
other (non-equity) securities.
Short-term Treasury debt is often referred to as ___________________
because of its high liquidity.
secondary reserves
Loans are (74% of assets)bank's income-earning assets, such as
business loans, auto loans, and ________________. Most banks tend to specialize in either consumer loans or business loans, and even take that as far as loans to specific groups (such as a par
mortgages - least liquid
Asset transformation is
when a bank takes your savings deposits and uses the funds to make, say, a mortgage loan.
When you deposit $100 in the Bank its assets__________by $100.
i.e. its reserves increase by $100
increase
The bank has four primary concerns:
Liquidity- management
Asset Management- Managing credit risk and Managing interest-rate risk
Liability management
Managing capital adequacy
With 10% reserve requirement, bank still has excess reserves of $1 million:
($10 million x 10% = $1 million)
no changes needed in balance sheet
Deposit outflow of $10 million
If a bank has $200,000 of deposits, a required reserve ratio of 20 percent, and $80,000 in reserves, then the maximum deposit outflow it can sustain
without altering its balance sheet is $50,000 (How?)
Step 1. (Deposits - Maximum Deposit Outflow ) x Required Reserve Ratio
(200,000 - Maximum Deposit Outflow) x 20%
Step 2. Reserves - Maximum Deposit Outflow
80,000 - Maximum Deposit Outflow
Step 4. Set step 1 = step 2 and Maximum Deposit Outflow be X
(200,
Asset Management:
the attempt to earn the highest possible return on assets
while minimizing the risk.
Get borrowers with low default risk, paying high interest rates
Buy securities with high return, low risk
Diversify
Manage liquidity
Liability Management:
managing the source of funds, from deposits, to CDs, to other debt.
Banks now manage both sides of the balance sheet together
asset-liability management (ALM) committee.
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.
Impact of $5 million loan loss
Conclusion: A bank maintains reserves to lessen the chance that it will become insolvent.
. So, why don't banks hold want to hold a lot of capital??
Higher is bank capital, lower is return on equity
ROA = Net Profits / Assets
ROE = Net Profits / Equity Capital
ROE = ROA X EM
EM = Assets/Equity Capital
Equity Multiplier (EM) is the amount of assets per dollar of equity capital.
Example:
A = D + E
$5 = $4 + $1 (EM is 5)
...
Housing boom and bust led to large bank losses, including losses ____________
on which had to be recognized on the balance sheet
SIVs (structured investment vehicles)
Loan sales (secondary loan participation)
Fee income from
*Foreign exchange trades for customers
*Servicing mortgage-backed securities
*Guarantees of debt
*Backup lines of credit
Trading Activities and Risk Management Techniques
Financial futures and options
*Foreign exchange trading
*Interest rate swaps
All these activities involve risk and potential conflicts
So examples of off-balance-sheet activities include
So examples of off-balance-sheet activities include
*loan sales
*foreign exchange market transactions.
*trading in financial futures.
Operating income
The largest source of income is interest on loans.
Operating expenses
The largest operating expense is interest paid on deposits
The Comptroller of the Currency regulatory body ____________
charters national banks
The Federal Reserve Act required all national banks to become members of the Federal Reserve System, while___________________to become members of the system.
state banks could choose
With the creation of the ___________________________, member banks of the Federal Reserve System were required to purchase FDIC insurance for their depositors, while nonmember commercial banks could choose to buy deposit insurance.
Federal Deposit Insurance Corporation
Dual banking system
The regulatory system that has evolved in the United States whereby
banks are regulated at the state level, the national level, or both.
In 1999, Glass-Steagall was repealed.
Commercial banks, which previously had to sell off investment
banking arms, now engaged again in securities activities.
Some of this business has been replaced by the shadow banking system (non-depository), in which
bank lending has been replaced by lending via ________________.
the securities market
____________are an example of the reply to interest-rate volatility
Adjustable-Rate Mortgages
Banks also started using _____________________ , and
intermediaries (like the CBOT-Chicago Board of Trade)
started developing extensive interest rate products.
derivates to hedge risk
Major change is improvement in information technology have:
lowered the cost of processing financial transactions, making it profitable for financial institutions to create new financial products and services
made it easier for investors to acquire information, thereby making it easier for firms to issue securitie
Junk bonds
__________are High-yield bonds rated below investment grade by the bond-rating
agencies.
___________ refers to the transformation of illiquid assets into marketable capital market instruments.
Securitization
The practice of creating marketable debt instruments that are backed by otherwise illiquid assets is known as _______________.
securitization.
Money Market Mutual Funds (MMMFs):
allow investors similar access to their funds as a bank savings accounts, but offered higher rates, especially in the late 1970s.Currently, MMMFs have assets around $10 trillion. In an odd irony, risks taken by MMMFs almost brought down the industry in 20
Sweep Accounts:
Funds are "swept" out of checking accounts nightly and invested at overnight rates. Since they are no longer checkable deposits, reserve requirement taxes are avoided.
Stripping" a Treasury bond means selling each of its future payments as a separate zero-coupon bond. How?
Take a simple 10-year, 10% coupon bond with a face value of $1,000,000, and is selling at par. The first $50,000 interest payment in six months is worth $47,673. But because investors found it less risky, they are willing to accept a
yield lower than 10%.
Bank Holding Companies (BHCs)
*Allowed purchases of banks outside state
*BHCs allowed wider scope of activities by Fed
*BHCs dominant form of corporate structure for banks
______________ Fed, OCC, FDIC are allowing banks to engage in underwriting activities, under the Section 20 loophole in the act
Erosion of Glass-Steagall
Thrift Industry: S&Ls:
Office of the Comptroller of the Currency regulates federally insured S&Ls by setting minimum capital requirements, requiring periodic reports, and examinations.
Similar to S&Ls but are jointly owned by the depositors
Thrift Industry: Mutual Saving Banks
Mutual funds
pool the resources of many small investors by selling these investors shares and using the proceeds to buy securities.
allow small investors to obtain the benefits of lower transaction costs in purchasing securities.
provide small investors a diversified
There are five principal benefits of mutual funds:
Liquidity intermediation: investors can quickly convert investments into cash while still allowing the fund to invest for the long term.
Denomination intermediation: investors can participate in equity and debt offerings that, individually, require ore ca
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.
Open-End Fund:
investors may buy or redeem shares at any point. Price is determined by the net asset value of the fund. An advantage to investors of an open-end mutual fund. The fund agrees to redeem shares at any time.
________________________
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
Net Asset Value (NAV)
NAV= (Total Assets - Liabilities) / outstanding shares
Net Asset Value (NAV) formula
There are four primary classes of mutual funds available to investors:
Stock (equity) funds
Bond funds
Hybrid funds
Money market funds
_______________________
seek rapid increase in share price, not being concerned about dividends.
Capital Appreciation Funds
_________________
seek a balance of current income and capital appreciation.
Total Return Funds
_________________ invest primarily in foreign firms.
World Equity Funds
______________________
invest primarily in U.S. corporate bonds, seeking a high level of current income.
Strategic Income Funds
____________________
invest in U.S. Treasury, as well as state and local government bonds
(default risk-free, but will have relatively low return.
Government Bond Funds
_______________________
Combine stocks and bonds into a single fund.
Account for about 5% of all mutual fund accounts
Hybrid Funds
__________________are Open-end funds that invest only in money market securities. - Offer check-writing privileges. - are not federally insured. - are relatively safe assets.
Money Market Mutual Funds (MMMF)
________________________________
They have lower fees
They select and hold stocks to match the performance of a stock index.
They do not require managers to select stocks and decide when to buy and sell.
A special class of mutual funds that do fit into an
Features of index funds
________________ (class A shares)
charge an upfront fee for buying the shares.
Load funds
__________________
funds do not charge this fee. Example: Index funds- no-load fund
No-load
_________________ (class B shares) funds
charge a fee when the shares are redeemed.
Deferred load
If the particular fund charges no front or back end fees,
it is referred to as class ________________
C shares.
contingent deferred sales charge:
a back end fee that may disappear altogether after a specific period.
redemption fee:
another name for a back end load
_________________ a fee (usually low) for transferring money between funds in the same family.
exchange fee:
_________________ charges if the account balance is too low.
account maintenance fee:
___________________ fee to pay marketing, advertising, and commissions.
12b-1 fee:
Mutual funds are regulated by four primary laws:
Securities Act of 1933: specifies disclosure requirements
Securities Exchange Act of 1934: details antifraud rules
Investment Company Act of 1940: requires registration and minimal operating standards
Investment Advisors Act of 1940: regulates fund adviso
Hedge Funds
A special type of mutual fund that received considerable attention following the collapse of Long Term Capital Management.
hedge funds:
High minimum investment, averaging around $1 million
Long-term commitment of funds is required
High fees: typically 1% of assets plus 20% of profits
Highly levered
Little current regulation
Different from typical mutual funds, as follows:
____________________
are often trying to take advantage of unusual spreads between security prices
Hedge funds
At ______________ the managers that 29.5-year U.S. Treasury bonds seemed cheap
relative to 30-year Treasury securities.
LTCM,
___________________________
was a hedge fund run by John Meriwether
(the former head of bond trading at Salomon Brothers),
and its board included Nobel Laureates Myron Scholes & Robert C. Merton.
It recorded returns in excess of 30% for the first several
Long Term Capital Management
Long Term Capital Management
However, it took bets that went the wrong way.
Its collapse was eminent, and regulators decided they had to develop a
bailout.
LTCM had over $80 billion in equity positions and over $1 trillion in derivative positions. Its failure could have been devastat
____________________loss $6 billion in one week in natural gas futures.
Amaranth Advisors
_______________________
allowing trades after 4:00 pm to trade at today's 4:00
NAV instead of tomorrow's price.
This is illegal under SEC regulations.
Late trading:
___________________
taking advantage of time zone differences for determination of NAV.
This is not illegal under SEC rulings
Market timing:
______________________
was charged with allowing traders to engage in market timing, paying
$250 million in fines and restitution to shareholders.
Alliance Capital Management Corp.
in a sample of the largest 88 mutual fund companies,
which represented 90% of the industry's assets, the SEC said that
about 25% of the broker-dealers were allowed to make _________________
illegal late trades.
__________________________
Insurance companies assume the risk of their clients in return for a fee.
Premium
________________________
because they are risk-averse �
they would rather pay a certainty equivalent
(the premium) than accept a gamble.
Most people purchase insurance
Although there are many types of insurance and insurance companies,
there are seven basic principles all insurance companies are subject to:
There must be a relationship
between the insured and the beneficiary.
The beneficiary must be someone who would suffer
if it weren't for the insurance.
The insured must provide full and accurate information
to the insurance company.
3. The insured is not
Although there are many types of insurance and insurance companies,
there are seven basic principles all insurance companies are subject to:
If a third party compensates the insured for the loss,
the insurance company's obligation is reduced by the amount of the
compensation.
The insurance company must have a large number of insured
so that the risk can be spread out among many different polic
_________________, the presence of adverse selection and moral hazard impacts the industry, but is fairly well understood the insurance companies.
As with other industries
____________________
occurs when those most likely to get large insurance payoffs are the ones
who want to purchase insurance the most.
Adverse selection
_______________________
occurs when the existence of insurance encourages the insured party to
take risks that increase the likelihood of an insurance payoff.
Moral hazard
Insurance management tools that give policyholders incentives to avoid accidents insured against include:
Deductibles
risk-based premiums
coinsurance
__________________________
may sell the insurance products of a number of different insurance companies.
Independent agents
__________________
only sell the products of one company.
Exclusive agents
___________________
reviews each policy prior to its acceptance to determine
if the risk is acceptable.
An underwriter
_________________
is owned by shareholders
and has a profit motive
A stock company
A __________________
is owned by the policyholders
and attempts to provide the
lowest cost insurance
mutual insurance company
Insurance is classified by which type of undesirable event is covered:
Life, Health, Property and Casualty
Life Insurance
Life insurance policies come in many forms. Some of the typical policies include: Term- the insured is covered
while the policy is in effect, usually 10-20 years. (NO savings element), Whole- similar to term life,
but allows the policyholder to borrow aga
_____________________________
usually requires the insured to pay a level premium
for the duration of the policy, and
the overpayment accumulates as a cash value that can be borrowed by
the insured at reasonable rates
Whole life insurance policy
Life insurance companies have two primary liabilities:
Life insurance payouts
Pension fund payouts
_______________________________
are highly vulnerable to the adverse selection problem. Those with known or expected health problems are more likely to seek coverage.
Health insurance policies
This is why most health insurance is offered through group policies.
Individual policies must be priced assuming adverse selection.
_____________________
protects businesses and owners from the risk associated with ownership.
Property Insurance:
_________________________
insures against any losses only from perils specifically named in the policy
Named-peril policies:
________________________
insures against any losses except from perils specifically named in the policy
Open-peril policies:
______________________
it protects against financial losses because of a claim of negligence.
Casualty Insurance (also known as liability insurance)
___________________
allocates a portion of the risk to another company
in exchange for a portion of the premium.
Reinsurance
_______________________
based on the 9-11 attacks in NYC,
new legislation was passed in 2002 limiting the amount insurance firms
would be required to pay out in the event of future attacks
Terrorism Risk Insurance Act of 2002:
_________________
explicitly exempts insurance companies from any type of federal regulation.
The McCarran-Ferguson Act of 1945
Most insurance regulations is at the _______________
state level
__________________________(financial guarantors)
specialize in credit insurance and are the only insurance companies that
are allowed to provide insurance that guarantees the timely repayment of
bond principal and interest when a debt issuer defaults. All
Monoline insurance companies
___________________________
A company's pension plan promises employees a specific amount of
income when they retire. However, the plan does not have the assets to
meet these future obligations to employees.
This plan represents a defined-benefit plan tha
Defined-Benefit Pension Plans:
Example: Annual Retirement Payment
= 2% x average of final 3 years' income x years of service
___________________________
a plan where a set amount is invested for retirement, but the benefit payout is uncertain.
Defined-Contribution Pension Plan:
Private Pension Plans: any pension plan set up by employers, groups, or individuals
Public Pension Plan: any pension plan set up by a government body for the general public (e.g., Social Security)
____________ is "Pay as you go system",
where current funding is used (partially) to pay current benefits.
Social Security
Employee Retirement Income Security Act of 1974 (ERISA)
Established guidelines for funding
Allowed plan credit to transfer with employees
Established vesting requirements to gain plan benefits
Increased disclosure requirements
Assigned regulatory oversight to the Department of Labor
Pension Reform Act of 1978
authorized individual retirement accounts (IRAs)
Enjoy a preferential tax treatment
Keogh plans are similar plans for self-employed individuals
SIMPLE IRAs are simplified retirement plans for small businesses.
Pension Protection Act of 2006
was passed to
___________________
perform a variety of crucial functions in financial markets
Underwrite the initial sale of stocks and bond
Deal maker in mergers, acquisitions, and spin-offs
Middleman in the purchase and sale of companies
Private broker to the very we
Investment banks
Investment banks were essentially created in the U.S. by the passage of the _________________ Prior to this, investment banking activities were part of large, money-center commercial banks.
Glass-Steagall Act.
The lines between_________________________________
again begins to blur as legal separation between investment banks
and commercial banks is no longer required.
investment banks and commercial banks
_____________
play many roles in both the primary and secondary markets.
Investment banks
The process of_______________a stock or a bond issue requires that the investment banker purchase the entire offering at a predetermined price and then resell the offering (securities) in the market.
underwriting
...............sell new securities to the public
Investment banks
...............sell existing securities to the public.
Brokerage firms...
A portion of the registration statement known as ______________________is made available to the public.
the prospectus
By law, investors must be given a portion of the registration statement before they can ____________in a new security.
invest
_________________, the investment banker may also arrange for the securities to appear on one of the exchanges.
Equity issues
_____________ require several additional steps, including acquiring a credit rating, hire a bond counsel, etc.
Debt issues
---------------------------------
The investment banker purchases the entire offering at a fixed price and then resells the offering to the market.
Underwriting (firm commitment
An underwriter may form an underwriting ________________ to diffuse part of the underwriting risk.
syndicate
____________ An alternative to a firm commitment, the underwriter does not buy the issue, but rather makes its "best effort" to sell the entire issue.
Best Efforts:
The entire issue is sold to a small, select group of
investors. This is rarely done with equity issues.
Private Placements:
_____________________
when a firm sells an entire division (or maybe the entire company), enlisting the aid of an investment banker.
Equity Sales:
Dealers make markets by standing ready to buy and sell at given prices
Brokers are pure middlemen
______________sell a security you don't own with the intent of buying it back at a later date (hopefully at a lower price)
Short Sales:
____________________when you call a brokerage house to buy or sell a security,
you essentially have three options:
Market- buy/sell at current price
Limit- specifically the most you're wlling to buy
Securities Orders:
________________offer clients research and investment advice, but usually charge a higher commission on trades.
Full Service Brokers
______________provides facilities to buy/sell securities but offers no advice. Many on-line discount brokerage firms do have significant research available.
Discount Broker:
______________
Hold inventories of securities on their own account
Provide liquidity to the market by standing by ready to buy or sell securities (market maker)
Especially important for thinly traded securities
Securities Dealers
________________stipulated that investment banking and commercial banking would be separated
Glass-Steagall
________________ removed some of these barriers.
G-L-B (Gramm-Leach-Bliley) Act
_______________ are slowly gaining regulatory permission to engage in the full range of services offered by investment banks.
Commercial banks
A __________________ is a specialized firm that finances young, start-up companies: provide funds for start-up companies
venture capital firm
________________
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.
Credit risk
____________is a problem in the market for loans because those with the highest credit risk have the biggest incentives to borrow from others.
Adverse selection
_______________ Once a borrower has a loan, she has an incentive to engage in risky projects to produce the highest payoffs, especially if the project is financed mostly with debt.
Moral hazard
_____________
- collecting reliable information about prospective borrowers.
- requiring certain actions, or prohibiting others, and then periodically verifying that the borrower is complying with the terms of the loan contact.
Screening and Monitoring:
_______________ helps in screening.
Specialization in Lending
Financial institutions write _______________into loans contracts and actively manage them to ensure that borrowers are not taking risks at their expense.
protective covenants
_____________past information contained in checking accounts, savings accounts, and previous loans provides valuable information to more easily determine credit worthiness.
Long-term Customer Relationships:
________________arrangements where the bank agrees to provide a loan up to a fixed amount, whenever the firm requests the loan.
Loan Commitments:
A bank's commitment (for a specified future period of time) to provide a firm with loans up to a given amount at an interest rate that is tied to a market interest rate.
A line of credit (example)
___________________ a pledge of property or other assets that must be surrendered if the terms of the loan are not met . (i.e. secured loans)
Collateral:
_____________________reserves that a borrower must maintain in an account that act as collateral should the borrower default.
Compensating Balances:
_______________
(a) lenders will refuse to lend to some borrowers, regardless of how much interest they are willing to pay, or
(b) lenders will only finance part of a project, requiring that the remaining part come from equity financing.
Credit Rationing:
Managing Interest-Rate Risk
Financial institutions can measure and manage interest-rate risk exposure using the following tools:
Income Gap Analysis (short term focus)
Duration Gap Analysis (long term focus)
_______________________measures the sensitivity of a bank's current year net income to changes in interest rate. requires determining which assets and liabilities will have their interest rate change as market interest rates change.
Income Gap Analysis
Determining Rate Sensitive Items (assets and liabilities)
Rate-Sensitive Assets (RSA)
= $5m + $ 10m + $15m + 20% x $20m = $32m
Rate-Sensitive Liabs (RSL)
= $5m + $25m + $5m + $10m + 10% x $15m + 20% x $15m = $49.5m
if interest goues up 5%
Asset Income = +5% x $32.0m = $ 1.6m
Liability Costs = +5% x $49.5m = ($ 2.5m) costs
Income = $1.6m x $ 2.5 = - $ 0.9m
GAP = RSA - RSL
= $32.0m - $49.5m = - $17.5m
Income = GAP x i
= -$17.5m x 5% = - $0.9m
NIM=(Interest income-interest expenses)
______________________________
assets
Also called net yield on interest earning asset
If a bank has more rate-sensitive liabilities than rate-sensitive assets,
then an increase in interest rates will reduce bank profits
Gap Analysis: GAP = RSA - RSL
Measuring the sensitivity of bank profits to changes in interest rates by multiplying the gap times the change in the interest rate
Basic Gap Analysis: Change in Income = GAP x change in interest rate
___________________________ is a complement to basic gap analysis that accounts for the effect of interest rate changes on market value.
Duration Gap Analysis
Owners and managers do care about the impact of interest rate exposure on current ______________. They are also interested in
the impact of interest rate changes on the market value of balance sheet items and the impact on net worth.
net income.
_____________
measures the sensitivity of a bank's current year net income to changes in interest rate.
Requires determining the duration for assets and liabilities, items whose market value will change as interest rates change
Duration Gap Analysis:
The basic equation for determining the change in market value for assets or liabilities is:
...
Recall from the balance sheet that First National Bank has "Bank capital" totaling ______________. Following such a dramatic change in rate, the capital would fall to $3.4m.
$5m.
______________
causes the market value of a bank's net worth to rise, then the bank must have a positive duration gap.
If a decline in interest rates
_______________________
shorten duration of bank assets or lengthen duration of bank liabilities
To completely immunize net worth from interest-rate risk, set DURgap = 0
Strategies for Managing Interest-Rate Risk
________________________
Assumes slope of yield curve unchanged and flat
Manager estimates % of fixed rate assets and liabilities that are rate sensitive
Problems with GAP Analysis