fin 683 financial institutions management … 683 financial institutions management introduction ......

Professor Robert B.H. HauswaldKogod School of Business, AU

FIN 683Financial Institutions Management

Introduction

1/19/2016 Financial Intermediation: Introduction © Robert B.H. Hauswald 2

FIN 683The Economic Role of Banks

• Objective:develop a framework for (financial) decision making in financial institutions– analysis: interest-rate, credit, market, liquidity risks

– balance-sheet management techniques

– applications: case studies• Perspective: commercial banking

– recent/current banking crisis as backdrop– shifting competitive and regulatory environment


Why FIN 683?

• Banks are different from any other companies– vital for the functioning of modern economies: why?– heavily regulation

• Recent banking crisis illustrates– specialness of banks– conflicts of interest between various parties

• The course is NOT about– the financial-services industry per se, or– managing and resolving banking crises

… but rather financial analysis for bank management


Administrativa: Robert Hauswald(administrativum: heaviest known element, very dangerous!)

• Office hours: before/after class, by appointment– let me know if you want to see me and why

• Email: [email protected]– speediest service “better than office hours”

• Phone, Fax: 202-885-1996, 202-885-1946

• Cases: order directly from Harvard (to keep cost down)– HBSP URL given in the syllabus

• Course URL on my website: link on the left– lecture notes, readings, homework assignments

– download before class


Requirements

• Pre-requisites: 614• Grade: 60% individual, 40% joint effort• Individual effort: deepen your understanding

– Finance Lab exercise (20%): Bank Data and Analysis– midterm (40%): personal products– class contribution (tie breaker): names, get to be known

• Group effort: learn together– 2 cases (20%) : executive summaries (2 pages), write-ups

(2 pages exec sum. + max 6 app.), presentations– final project (20%): an analyst report on a recent bank in

trouble or a bank problem (see syllabus and URL)


Cases and Presentations

• Workgroups: 2 to 3 students per group, peer review– prepare cases in advance and lead discussion: write-ups

due at the beginning of class– 2 pages of analysis (executive summary) plus maximally

6 pages of appendices for write-ups– presentations: be professional (play the part), prepared

(“show”, slides, material) and convincing – grade: Presentation, Professionalism, Style, Integration,

Orginality, Analysis, Perspective, Form• Group project: analyst report on recent bank issues

– pick problem or institution, analyze it, write report– bonus points: complete case study with ancillary materials


Readings and Materials

• Saunders and Cornett, Financial Institutions Management, 8th ed., McGraw-Hill 2014

• Freixas and Rochet (2008), Microeconomics of Banking, MIT Press

• Tuckman, Fixed Income Securities, 2nd ed., Wiley 2002

• Cases : buy directly from HBSP at http://cb.hbsp.harvard.edu/cb/access/44590861

• Lecture notes: posted on course website• Financial Times subscription: free for AU

– search the library website


How to Succeed

• Come to class– no absence except for emergencies: courtesy of email

• Contribute to class discussion– success of learning experience relies on you

• Do you work: reading, case preparation– read cases ahead of time

• Practice the techniques: do the math!– technical course: sound analysis precedes sound strategy

• Be curious and creative– be a resource to your classmates!


Course Outline by Themes

1. Introduction: The role of Banks

2. Foundations 1: Of Lenders and Borrowers

3. Foundations 2: Bank Risks

4. Interest-Rate Risk: Duration and Convexity

5. Market Risk: Liquidity Risk, VaR

6. Credit Risk: Aggregating Risk, Derivatives

7. Regulation: Deposit Insurance, Capital Adequacy

8. Disintermediation: The Crisis and Incentives

9. Conclusion: The Take-away


Banks Are Special

• Economic importance: help overcome frictions– credit crunches: exacerbate business cycles

• Coordination failures– monitoring

– bank runs

• Risk transfers– insurance

– risk shifting

• Financial regulation and supervision matter!


Bank Runs only Occur in Developing Countries…

Why Do Financial Intermediaries Exist?

• The classical theories– asset transformation

– transaction costs

– liquidity services: payment systems

• First-generation models– delegated monitoring and liquidity services

• Second generation models– financial intermediaries and financial markets


Preliminaries: the Balance Sheet

• A balance sheet for a– company is:

– bank is:

• What is special about financial intermediaries? – deposits

– loans

– equity

• Contracts are not necessarily standard– not anonymous: cannot easily be resold


What is the Difference to Mutual Funds?

1/19/2016 14Financial Intermediation: Introduction © Robert B.H. Hauswald

The Classical Theory 1: Transaction Costs

• A transaction cost approach: e.g., Benstonand Smith (1976)

• Institutions exist because they allow to diminish contracting costs:1. costs of becoming informed

2. costs of structuring, administering and enforcing financial contracts

3. cost of transferring financial claims


The Classical Theory 2:Asset Transformation

• Transformation of assets: e.g., Gurley and Shaw (1960)– maturity

– convenience of denomination

– risk: indivisibilities, (Merton, 1989)

• Implicit assumption: – these asset transformation services are provided

more efficiently outside the firm.


The Classical Theory 3:Payment and Liquidity Services

• The classical theory 3: liquidity services– payment system: Fama (1980)

• Implications: banks realize– economies of scale

– economies of scope

– reputational capital

– reduction in search costs


Modern Theories: First Generation

• Diamond and Dybvig (1983): – Liquidity insurance

– Ex ante uncertainty defines the liquidity shock

• The delegated monitoring approach - CSV: Diamond (1984); Gale and Helwig (1985)– explains existence and function of banks

– shows why two-sided debt contract is optimal: incentives to reveal information


Diamond and Dybvig: Model

• Main thrust: analyze bank runs as coordination failures

• Model also explains existence of banks– storage

– liquidity transformation

• Setting: game-theoretic analysis– one good

– three period economy1/19/2016 Financial Intermediation: Introduction © Robert B.H. Hauswald 19

Market Failure

• Market solution: suboptimal if liquidity demand is uncertainty, e.g., life expectancy– early diers consume 1

– late diers consume R which is not ex ante efficient

• Financial intermediation may provide deposits – entail a larger consumption for early diers and

lower consumption for late diers

– thus reaching the efficient allocation.

1/19/2016 Financial Intermediation: Introduction © Robert B.H. Hauswald

Intertemporal Smoothing

• Allen and Gale (1997) extend DD 1983 by incorporating a role for intertemporal smoothing – some generations face a large return, others a

smaller one.

– since each generation lives only two periods, it cannot enter an explicit insurance contract.

• Banking provides this type of insurance and is ex ante Pareto efficient.– ex ante uncertainty defines the liquidity shock


Debt Contracts

• A complete contingent contract would have to specify in every state and at every date,1. the amount of repayment or (possibly) the amount of

additional loan,

2. the interest rate on the remaining debt,

3. a possible adjustment in the collateral required by the lender,

4. the actions (in particular investment decisions) to be undertaken by the borrower.

• In practice, debt contracts are very simple1/19/2016 Financial Intermediation: Introduction © Robert B.H. Hauswald 22

Complexity of Contingent Contracts

• Contract is specified for whole duration: contingencies are rarely taken into account– Repayments (Additional loans)

– Collateral

– The borrower’s actions (investment)

• However, debt covenants include a large number of contingencies– in practice, not renegotiation proof


The Standard Debt Contract

• Definition: fixed repayment with maximal recovery in case of default– repayment is independent of cash flows

– If the cash flows are insufficient, all assets go to the lenders

– If cash flows are insufficient, lenders get control of the firm

• State-contingent change of control: default– NB: requires lots of legal and other infrastructure


Borrower’s cash flows

Rep

aym

ent

Standard Debt Contract (SDC)


CSV Advantage

• Integrated theory and joint derivation of– financial intermediation: delegated monitoring

– standard debt contracts: constant repayment, maximal recovery, i.e., realistic theory

– incentive-compatible efficient contracts

• Alternative derivation of incentive-compatible standard debt contracts – Innes (1990) : effort provision by entrepreneur

in the presence of limited liability1/19/2016 Financial Intermediation: Introduction © Robert B.H. Hauswald 26

Repayment Incentives and Contract Enforcement

• Suppose audit is impossible, but– legal mechanisms allows a lender to recover a fraction

of the cash flows and collateral of the lending firm. • The legal mechanisms could be more or less

efficient: two different models1. the fraction that is not recovered accrues to the

borrowing firm 2. the fraction that is not recovered is lost to a third

party. • Implications : different incentives for the

borrowing firm– different optimal debt contracts


Financial Intermediation and Markets: Second-Generation Models

• Co-existence of financial intermediaries and financial markets

• Agents differ by – their history of repayments

– their collateral

– their rating

– their information

• Financial intermediaries specialize in... 1/19/2016 28Financial Intermediation: Introduction © Robert B.H. Hauswald

Monitoring and Reputation

• Diamond (1991): a population of firms with investment projects of three different non-observable types1. high risk, high return and negative net

present value

2. low risk low return and positive net present value projects.

3. strategic firms which are able to choose their type between the two previous ones.


Fundamental Problem

• The main issue is the moral hazard problem for the strategic firms

• The difference between banks and markets– banks monitor strategic firms: FI as (ex post)

information production

– whereas bond markets do not or cannot

– banks have to pay a monitoring cost

• Key insight: good history firms will issue securities – signalling outcome


Monitoring and Collateral

• Holmstrom and Tirole (1995): moral hazard in project choice:– the entrepreneur chooses the probability of

success

– the project with a lower probability of success has private benefits B for the entrepreneur.

• The issue: pledgeable cash flow– one cannot contract ex ante on cash flow


Ex post Information Production

• The bank is able to monitor the choice of projects by diminishing B to b.

• If the firm brings in sufficient collateral, or a sufficient stake in the project – no monitoring is needed.

– otherwise monitoring is needed.


Monitoring Incentives

• Banks have an incentive to monitor– since they have a stake in the project

– differs from rating agencies: why should those monitor?

– interesting question: what would happen if rating agencies were allowed to trade/invest?

• What makes bank loans costly? – supply of loans is limited by the bank’s capital.


Why Banks?

• Banks exist for many economic reasons: there is no unique view, nor a unified theory

• Apart from transaction costs, the main reasons why financial intermediaries exist are– screening

– monitoring

– intertemporal insurance

• Information production and risk transfer1/19/2016 34Financial Intermediation: Introduction © Robert B.H. Hauswald


Equilibrium in Credit Market

• Competition among borrowers and lenders– prices: loan rates

– quantities: availability of credit

• Small informational frictions have huge consequences– backward-bending supply functions

– absence of equilibrium, i.e.,

– credit rationing in equilibrium


Backward-Bending Supply Curve

• Expected return on bank credit is not a monotonic function of the loan’s nominal rate– monopolistic bank: offers the maximum interest

rate R*

– monopolistic bank may decide to ration credit

• Problem: demand and supply do not intersect– consequence?

– how can you tell?


Backward-Bending Loan Supply

0 R

L

Supply curve

R*

L1

L2


Information Asymmetry in the Credit Market

• Ex ante: adverse selection – contract design affects the group of loan applicants

– screening applicants might help

• During the contract: moral hazard – the behavior of the applicants changes after signing

the contract;

– monitoring helps

• Ex post: costly state verification


The Second Dimension: Collateral

• The lender can use more parameters in a contract: besides repayment it has, e.g., collateral– we get a separation equilibrium: sort on borrower types– the interest rate could be a decreasing function of

collateral

• High risks pay a high interest rate but are not required to hand in collateral.

• Low risk projects have to put down some collateral, but pay a low interest rate

• Collateral can complement or substitute for borrower screening: “lazy banks”

2-40

Depository Institutions

• Business model of banks:– A:

– L:

– profits:

• Grand tour of depository FIs:– Size, structure, and composition

– Balance sheets and recent trends

– Regulation of depository institutions

– Depository institutions performance1/19/2016 Financial Intermediation: Introduction © Robert B.H. Hauswald

• Services include:

Federal Reserve Bank

Federal Reserve

Bank – is part of the central

banking system in the United States

Federal Reserve

Bank – is part of the central

banking system in the United States

Collecting checks

Collecting checks

Electronically transferring

funds

Electronically transferring

funds

Distributing and receiving cash and coin

Distributing and receiving cash and coin


Federal Reserve System: FRS


• Which federal reserve bank is located in your region?

2-43

Products of U.S. FIs

• Comparing the products of FIs in 1950, to products of FIs in 2007:– Much greater distinction between types of FIs

in terms of products in 1950 than in 2010

– Blurring of product lines and services over time and wider array of services

• Refer to Tables 2-1A and 2-1B in the text


2-44

Specialness of Depository FIs

• Products on both sides of the balance sheet– expression of

– what is the problem?

• Loans– business and commercial: C&I

– retail

• Deposits


2-45

Other Products

• Other products and services 1950:– Payment services

– savings products

– fiduciary services

• By 2007, products and services expanded :– underwriting of debt and equity

– asset management

– insurance

– risk management products1/19/2016 Financial Intermediation: Introduction © Robert B.H. Hauswald

2-46

Structure and Composition

• Shrinking number of banks:– 14,416 commercial banks in 1985

– 12,744 in 1989

– 6,911 in 2009: 25 failures in 2008, 140 in 2009

– number of banks remaining in 2011? 157 failed in 2010, 40 so far in 2011

• Mostly the result of Mergers and Acquisitions– M&A prevented prior to 1980s, 1990s

– Consolidation has reduced asset share of small banks: more recently, failure!


2-47

Regulation, Functions & Structure

• Functions of depository institutions– Regulatory sources of differences across types

of depository institutions.

• Structural changes generally resulted from changes in regulatory policy– Example: Changes permitting interstate

branching

– Riegle-Neal Act


2-48

Breakdown of Loan Portfolios


2-49

Commercial Banks: Asset Concentration

Size

2009

Assets

Percent

of Total

1984

Assets

Percent

of Total

All FDIC

Insured

11,866.4 100.0 2,508.9 100.0

$100M or Less 142.9 1.2 404.2 16.1

$100M - $1B 1,104.2 9.3 513.9 20.5

$1B - $10B 1,158.9 9.8 725.9 28.9

$10B or more 9,460.4 79.7 864.8 34.5


2-50

Structure & Composition of Commercial Banks

• Financial Services Modernization Act 1999– allowed full authority to enter investment banking

and insurance

– Citigroup proves that you cannot do everything

• Limited powers to underwrite corporate securities have existed only since 1987

• Separation of underwriting and lending– artifact of the 1930s and great depression

– unclear whether beneficial or not to economy1/19/2016 Financial Intermediation: Introduction © Robert B.H. Hauswald

2-51

Balance Sheet and Trends

• Business loans have declined in importance– Offsetting increase in securities and mortgages

• Increased importance of funding via commercial paper market– interbank market: dangers?

• Securitization of mortgage loans

• Temporary effects: credit crunch during recessions of 1989-92, 2001-02, and 2008-2011


2-52

Commercial Banks: September 2009

• Primary assets:– Real Estate Loans: $3,799.3 B

– C&I loans: $1,210.7 B

– Loans to individuals: $959.1 B

– Investment security portfolio: $3,335.2 B

– Of which, Treasury securities: $1,225.5 B

• Inference: Importance of Credit Risk– market and liquidity risk


2-53

Commercial Banks

• Primary liabilities:– Deposits: $8,178.2 billion

– Borrowings: $2,065.6 billion

– Other liabilities: $307.4 billion

• Inference:– highly leveraged

– what is another view of our banking system?


2-54

Equity

• Commercial Banks equity capital– 2009: 11.08% of total liabilities and equity

• TARP program 2008-2009 intended to encourage increase in capital– Citigroup $25 B

– BOA $20 B

– by 2009: $300B in capital injections via TARP

• Take the money and run– attempt to curb payouts to shareholders


2-55

Off-Balance-Sheet Activities

• Heightened importance of off-balance-sheet items and activities– OBS assets, OBS liabilities

• Regulatory incentives: shift and hide– risks and costs

– profits

• Risk control and risk producing: MBS– “Toxic” assets

– Expansion of oversight1/19/2016 Financial Intermediation: Introduction © Robert B.H. Hauswald

2-56

Major OBS Activities

• Loan commitments

• Standby letters of credit and letters of credit

• Futures, forwards, and swaps

• When-issued securities

• Securitization deals– liquidity puts, residual risk guarantees


2-57

Other Fee-Generating Activities

• Trust services

• Correspondent banking– Check clearing

– Foreign exchange trading

• Hedging

• Participation in large loan and security issuances– Payment usually in terms of noninterest bearing

deposits1/19/2016 Financial Intermediation: Introduction © Robert B.H. Hauswald

2-58

Industry Performance• Economic expansion and falling interest rates

through 1990s

• Brief downturn in early 2000 followed by strong performance improvements– Record earnings $106.3 billion 2003

• Performance remained strong through mid 2000s as interest rates rose

• Late 2000s: Strongest recession since 1930s– the politics and policy of panicking politicians


Summary

• Fragmented banking system: historical artifact– rent seeking and political economy: vested interests

perpetuate inefficient system

• Specificity of industry sets it apart from other industries: macroeconomic importance– intermediaries: two sided market

– informational consideration and market failures

– individual failure (good) vs. systemic risk (bad)

• Competition and information: fascinating!1/19/2016 Financial Intermediation: Introduction © Robert B.H. Hauswald 59

Key Regulatory Agencies

• FDIC– DIF

– Role in preventing contagious runs or panics

• OCC: Primary function is to charter national banks

• FRS: Monetary policy, lender of last resort– National banks are automatically members of the FRS;

state-chartered banks can elect to become members

• State bank regulators

• Dual Banking System: coexistence of national and state-chartered banks – recipe for disaster

2-60 Financial Intermediation: Introduction © Robert B.H. Hauswald1/19/2016

2-61

Bank Regulators


2-62

Other Regulatory Issues

• Importance of Bank Holding Companies is increasing: conversion of WS to banks

• BHCs regulated by FRS

• Regulatory arbitrage

• Political economy of regulation– fragmented banking and regulatory system:

checks and balances good for democracy but…

– agencies become self-interested players1/19/2016 Financial Intermediation: Introduction © Robert B.H. Hauswald

2-63

Key Regulatory Legislation• 1927 McFadden Act: Controls branching of

national banks– predates great depression

• 1933 Glass-Steagall: Great Depression failures– Separates securities and banking activities

– established FDIC

– prohibited interest on demand deposits

• 1956 Bank Holding Company Act and subsequent amendments specify permissible activities and regulation by FRS of BHCs1/19/2016 Financial Intermediation: Introduction © Robert B.H. Hauswald

2-64

Recent Legislation• 1970 Amendments to the Bank Holding Company Act:

– Extension to one-bank holding companies

• 1978 International Banking Act: Regulated foreign bank branches and agencies in USA

• 1980 DIDMCA and 1982 DIA (Garn-St. GermainDepository Institutions Act)– Mainly deregulation acts

– Phased out Regulation Q

– Authorized NOW accounts nationwide

– Increased deposit insurance from $40,000 to $100,000

– Reaffirmed limitations on bank powers to underwrite and distribute insurance products


2-65

Legislation and S&L Crisis

• 1987 Competitive Equality in Banking Act (CEBA)– Redefined bank to limit growth of nonbank banks

• 1989 FIRREA– Imposed restrictions on investment activities

– Replaced FSLIC with FDIC-SAIF

– Replaced FHLB with Office of Thrift Supervision

– Created Resolution Trust Corporation

• 1991 FDIC Improvement Act– Introduced Prompt Corrective Action

– Risk-based deposit insurance premiums

– Limited “too big to fail”

– Extended federal regulation over foreign bank branches and agencies


2-66

Catching up with the Market

• 1994 Riegle-Neal Interstate Banking and Branching Efficiency Act– Permits BHCs to acquire banks in other states

– Invalidates some restrictive state laws.

– Permits BHCs to convert out-of-state subsidiary banks to branches of single interstate bank

– Newly chartered branches permitted interstate if allowed by state law


2-67

1999 Financial Services Modernization Act

• Allowed banks, insurance companies, and securities firms to enter each others’ areas

• Provided for state regulation of insurance

• Streamlined regulation of BHCs

• Prohibited FDIC assistance to affiliates and subsidiaries of banks and savings institutions

• Provided for national treatment of foreign banks


2-68

Financial Services Regulatory Overhaul Bill

• Financial Services Oversight Council

• Power to break up FIs that pose a risk to the system: systemic risk regulator

• Consumer Financial Protection Agency

• GAO audit of Federal Reserve Activities

• Nonbinding proxy on executive pay

• Clearinghouses for some derivatives


fin 683 financial institutions management … 683 financial institutions management introduction ......

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