Week-8 Stock Market Rational Expectations and Financial & Bank Structure Continued

Money and Banking Econ 311Tuesdays 7 - 9:45

Instructor: Thomas L. Thomas

The Bank Balance Sheet (cont’d)

Assets Reserves Cash items in process of collection Deposits at other banks Securities Loans Other assets – give some examples?

The Bank Balance Sheet Liabilities

Checkable deposits Nontransaction deposits – give some examples Borrowings Bank capital

What are core deposits?

Table 1 Balance Sheet of All Commercial Banks (items as a percentage of the total, June 2011

Basic Banking: Cash Deposit

Opening of a checking account leads to an increase in the bank’s reserves equal to the increase in checkable deposits

First National Bank First National Bank

Assets Liabilities Assets Liabilities

Vault Cash

+$100 Checkable deposits

+$100 Reserves +$100 Checkable deposits

+$100

Basic Banking: Check Deposit

First National Bank Second National Bank

Assets Liabilities Assets Liabilities

Reserves +$100 Checkable deposits

+$100 Reserves -$100 Checkable deposits

-$100

First National Bank

Assets Liabilities

Cash items in process of collection

+$100 Checkabledeposits

+$100

Basic Banking: Making a Profit

Asset transformation: selling liabilities with one set of characteristics and using the proceeds to buy assets with a different set of characteristics

The bank borrows short and lends long

First National Bank First National Bank

Assets Liabilities Assets Liabilities

Required reserves

+$10 Checkable deposits

+$100 Required reserves

+$10 Checkable deposits

+$100

Excess reserves

+$90 Loans +$90

General Principles of Bank Management

Liquidity Management Asset Management Liability Management Capital Adequacy Management Credit Risk Interest-rate Risk

Liquidity Planning

Three Types:

Tactical

Strategic

Contingency

Liquidity Management: Ample Excess Reserves

Suppose bank’s required reserves are 10% If a bank has ample excess reserves, a deposit

outflow does not necessitate changes in other parts of its balance sheet

Assets Liabilities Assets Liabilities

Reserves $20M Deposits $100M Reserves $10M Deposits $90M

Loans $80M Bank Capital

$10M Loans $80M Bank Capital

$10M

Securities $10M Securities $10M

Liquidity Management: Shortfall in Reserves

Reserves are a legal requirement and the shortfall must be eliminated

Excess reserves are insurance against the costs associated with deposit outflows

So what could a bank do?

Assets Liabilities Assets Liabilities

Reserves $10M Deposits $100M Reserves $0 Deposits $90M

Loans $90M Bank Capital

$10M Loans $90M Bank Capital

$10M

Securities $10M Securities $10M

Liquidity Management: Borrowing

Cost incurred is the interest rate paid on the borrowed funds

What type borrowing can the bank do?

Assets Liabilities

Reserves $9M Deposits $90M

Loans $90M Borrowing $9M

Securities $10M Bank Capital $10M

Liquidity Management: Securities Sale

The cost of selling securities is the brokerage and other transaction costs

Assets Liabilities

Reserves $9M Deposits $90M

Loans $90M Bank Capital $10M

Securities $1M

Liquidity Management: Federal Reserve

Borrowing from the Fed also incurs interest payments based on the discount rate

Fed used to be considered the lender of last resort to banks – this is no longer the case.

(note the Fed is a profit making institution for its members.)

Assets Liabilities

Reserves $9M Deposits $90M

Loans $90M Borrow from Fed $9M

Securities $10M Bank Capital $10M

Liquidity Management: Reduce Loans

Reduction of loans is the most costly way of acquiring reserves

Calling in loans antagonizes customers Other banks may only agree to purchase loans at a

substantial discount

Assets Liabilities

Reserves $9M Deposits $90M

Loans $81M Bank Capital $10M

Securities $10M

Asset Management: Three Goals

1. Seek the highest possible returns on loans and securities

2. Reduce risk Concentration management

3. Active Credit Management

4. Have adequate liquidity (ALLL)

Asset Management: Four Tools

1. Find borrowers who will pay high interest rates and have low possibility of defaulting – Risk Adjusted Pricing

2. Purchase securities with high returns and low risk

3. Lower risk by diversifying

4. Balance need for liquidity against increased returns from less liquid assets

Asset Management: Tools

1. Screening – Adverse selection in the loan markets requires lenders screen out bad credits. This requires collecting information and developing a system to evaluate the risk called underwriting. Risk ratings and FICO scores are numerical constructs to evaluate credit risk.

2. Specialized lending – banks often specialize in lending to specific groups or firms in particular industries. The more knowledgeable about the industries they are lending to the better the bank is able to predict which firms are better credit risks.

3. The uses of Monitoring and Restrictive covenants to modify borrower behavior.

4. Collateral – to reduce exposure and modify behavior.

5. Developing long-term relationships (know your customer) – by issuing loan commitments (credit lines) tied to some market rate generally LIBOR over some specified time – maturity.

6. Finally credit rationing – refusing to make loans to borrowers deemed to be too risky even though they are willing to pay higher rates. – Simply put declining a loan – note issues with fair lending.

Commercial Judgmental Credit Ratings

Moody'sStandard & Poor's

Fitch Credit worthiness

Aaa AAA AAA An obligor has EXTREMELY STRONG capacity to meet its financial commitments.Aa1 AA+ AA+Aa2 AA AAAa3 AA- AA-A1 A+ A+A2 A AA3 A- A-Baa1 BBB+ BBB+Baa2 BBB BBBBaa3 BBB- BBB-Ba1 BB+ BB+Ba2 BB BBBa3 BB- BB-B1 B+ B+B2 B BB3 B- B-

Caa CCC CCCAn obligor is CURRENTLY VULNERABLE, and is dependent upon favourable business, financial, and economic conditions to meet its financial commitments.

Ca CC CC An obligor is CURRENTLY HIGHLY-VULNERABLE.

C CThe obligor is CURRENTLY HIGHLY-VULNERABLE to nonpayment. May be used where a bankruptcy petition has been filed.

C D DAn obligor has failed to pay one or more of its financial obligations (rated or unrated) when it became due.

SD RDThis rating is assigned when the agency believes that the obligor has selectively defaulted on a specific issue or class of obligations but it will continue to meet its payment obligations on other issues or classes of obligations in a timely manner.

NR NR NR No rating has been requested, or there is insuffi cient information on which to base a rating.Source: Moody's, Standard & Poor's and Fitch Rating Agencies

An obligor has VERY STRONG capacity to meet its financial commitments. It differs from the highest rated obligors only in small degree.

An obligor has STRONG capacity to meet its financial commitments but is somewhat more susceptible to the adverse effects of changes in circumstances and economic conditions than obligors in higher-rated categories.An obligor has ADEQUATE capacity to meet its financial commitments. However, adverse economic conditions or changing circumstances are more likely to lead to a weakened capacity of the obligor to meet its financial commitments.An obligor is LESS VULNERABLE in the near term than other lower-rated obligors. However, it faces major ongoing uncertainties and exposure to adverse business, financial, or economic conditions which could lead to the obligor's inadequate capacity to meet its financial commitments.An obligor is MORE VULNERABLE than the obligors rated 'BB', but the obligor currently has the capacity to meet its financial commitments. Adverse business, financial, or economic conditions will likely impair the obligor's capacity or willingness to meet its financial commitments.

Typical 10 Grade Bank Rating System

Pass Ratings (Levels 1 - 6)1 Highest quality

2 Excellent quality

3 Good quality

4 Average quality

5 Acceptable quality

6 Minimum acceptable quality

Non-Pass Ratings (Levels 7-10)7 Special Mention

8 Substandard

9 Doubtful

10 Loss

Risk Grade 7 - Special Mention :Borrowers who exhibit potential credit weaknesses or downward trends deserving bank management's close attention. If not checked or corrected, these trends will weaken the bank's asset or position. While potentially weak, no loss of principal or interest is presently envisioned. As a result, special mention assets do not expose City National Bank to sufficient risk to warrant adverse classification. Included in special mention assets could be those borrowers in turnaround situations that are still in progress, as well as those borrowers previously Pass rated who have shown deterioration. Typically, start-up companies or those in deteriorating industries or those with poor and declining market share in an average industry are candidates. Borrower may be experiencing temporary operating losses, but still has positive cash flow. Cash flow may be volatile. Other characteristics include an element of asset quality or management that is below average. Management and owners may have limited depth and back up.

Risk Grade 8 – Substandard: Borrowers with well-defined weaknesses that jeopardize the orderly liquidation of debt. A substandard credit is inadequately protected by the current sound worth and paying capacity of the obligor or by the collateral pledged, if any. The borrower may exhibit negative cash flow. Negative or extremely volatile cash flow trends are expected to continue. Repayment from the borrower of all contractual principal and interest is in jeopardy, although no loss of principal is presently envisioned. There is a distinct possibility that a partial loss of interest and/or principal will occur if deficiencies are not corrected. Loss potential, while existing in the aggregate amount of substandard assets, does not have to exist in individual assets classified substandard. Management skills are questionable with readily identifiable voids.

Risk Grade 9 – Doubtful: Borrowers classified doubtful have the weaknesses found in substandard borrowers with the added provision that the weaknesses make collection or liquidation in full, on the basis of currently existing facts, conditions, and values, highly questionable and improbable. Serious problems exist to the point where partial loss of principal is likely. The possibility of loss is extremely high, but cannot be determined because of certain important and reasonably specific pending factors that may result in strengthening the assets. Pending factors include proposed merger, acquisition, or liquidation procedures; capital injection; perfecting liens on additional collateral; and refinancing plans. Specific reserves are generally established to provide for these uncertainties. Management has a demonstrated history of failing to live up to agreements, unethical or dishonest business practices, bankruptcy, and/or conviction of criminal charges. Relationship Managers should attempt to identify loss in the credit whenever possible, thereby limiting the excessive use of the Doubtful classification.

Risk Grade 10 – Loss: Advances to the borrower are in excess of the calculated current fair value of the collateral. Borrower is deemed incapable of repayment of unsecured debt. There is little or no prospect for near term improvement and no realistic strengthening action of significance pending. Credits to such borrowers are considered uncollectible and of such little value that continuance as active assets of the bank is not warranted. This classification does not mean that the credits have absolutely no recovery or salvage value, but rather, it is not practical or desirable to defer writing off these basically worthless assets even though partial recovery may be affected in the future.

o Expected Credit Loss composed of three items:o Probability of Default (PD)o Exposure at Default = [Outstanding Balance + CCF (Unused Line)]o Loss Given Default = (1-Recovery Rate)

PD x Exposure X LGD = Expected Loss → ALLL

o ALLL = Allowance for Loan and Lease Losses (e.g. Credit Loss Reserves)

Expected Credit Loss

Liability Management Recent phenomenon due to rise of money center

banks

Expansion of overnight loan markets and new financial instruments (such as negotiable CDs) have forced banks to pay higher rates reducing NIM and profit.

Checkable deposits have decreased in importance as source of bank funds.

As a result banks look closely at managing their funding sources and interest rate exposure – Note S&L crisis borrowing short lending long. Thereby focusing on interest rate and maturity gaps.

ALM – Managing Interest rate Risk

Traditional Gap Analysis – RSA – RSL

Refined in three ways (all three methods follow the matching principal in accounting): Maturity Bucket Approach – where RSA and RSL are

matched by buckets of similar maturity.

Standardized Gap Analysis – matches maturity and rates sensitivity by matching fixed vs. variable rate instruments.

Duration Gap – matches interest rate sensitivity of RSA and RSL so that the weighted duration for RSA is close to RSL

− EVE and NII Shock Testing usually +/- 300 basis points in 100 b.p. shocks

−Question – measure the maturity for credit lines and deposits without stated maturities?

Capital Adequacy Management

Bank capital helps prevent bank failure

The amount of capital affects return for the owners (equity holders) of the bank

Regulatory requirement – Regulatory Capital – Tier 1 and Tier 2 Basle Rules

Economic Capital - What is this

Capital Adequacy Management: Returns to Equity Holders

Traditional Economic Capital Value-At-Risk (VaR) View

Frequency of Occurrence / Probability

Mean/Average Expected Losses (m)

Unexpected Losses @ 99.9% confidence Level (s)

Economic CapitalReserves

Value-at-RiskVAR

Old Measure: New Ones

RAROC - Risk Adjusted Return on Capital

EVA - Economic Value Added.

Hurdle Rate – What is it. How is it measured?

Asymmetric Information and Financial Regulation

Bank panics and the need for deposit insurance: FDIC: short circuits bank failures and contagion effect. Payoff method. Purchase and assumption method (typically more

costly for the FDIC). Other form of government safety net:

Lending from the central bank to troubled institutions (lender of last resort).

Example TARP Funds Form of Purchase Assumption.

Government Safety Net

Moral Hazard Depositors do not impose discipline of marketplace. Financial institutions have an incentive to take on

greater risk. Adverse Selection

Risk-lovers find banking attractive. Depositors have little reason to monitor financial

institutions.

Government Safety Net: “Too Big to Fail”

Government provides guarantees of repayment to large uninsured creditors of the largest financial institutions even when they are not entitled to this guarantee

Uses the purchase and assumption method Increases moral hazard incentives for big banks Larger and more complex financial organizations

challenge regulation Increased “too big to fail” problem Extends safety net to new activities, increasing

incentives for risk taking in these areas (as has occurred during the global financial crisis

Restrictions on Asset Holdings

Attempts to restrict financial institutions from too much risk taking Bank regulations

Promote diversification – Concentration Managment Prohibit holdings of common stock

Capital requirements Minimum leverage ratio (for banks) Minimum Capital levels for Tier1 and Tier 2 Basel Accord: risk-based capital requirements Regulatory arbitrage

Capital Requirements

Government-imposed capital requirements are another way of minimizing moral hazard at financial institutions

There are two forms:

The first type is based on the leverage ratio, the amount of capital divided by the bank’s total assets.

To be classified as well capitalized, a bank’s leverage ratio must exceed (Get new leverage ratio)

A lower leverage ratio, especially one below 3%, triggers increased regulatory restrictions on the bank

The second type is risk-based capital requirements

Financial Supervision: Chartering and Examination

Chartering (screening of proposals to open new financial institutions) to prevent adverse selection

Examinations (scheduled and unscheduled) to monitor capital requirements and restrictions on asset holding to prevent moral hazard Capital adequacy Asset quality Management Earnings Liquidity Sensitivity to market risk

CAMAL Reports Filing periodic ‘call reports’

Financial Supervision: Chartering and Examination

CAMEL Ratings 1- 5 (5 being best): Four elements measured:

1. Oversight provided by management and board2. Policies and limits for all significant risk activities3. Quality of measurement and monitoring systems4. Internal controls to prevent fraud and abuse

MRAs and recommendations - now comon MIRAs mean trouble.

Disclosure Requirements

Requirements to adhere to standard accounting (GAP) principles and to disclose wide range of information

The Basel 2 accord and the SEC put a particular emphasis on disclosure requirements

The Sarbanes-Oxley Act of 2002 established the Public Company Accounting Oversight Board – Board and Management must sign-off on accuracy.

Mark-to-market (fair-value) accounting Issues of measurement Assumes liquidation value on non-liquid assets.

Restrictions on Competition

Justified as increased competition can also increase moral hazard incentives to take on more risk. Branching restrictions (eliminated in 1994) Glass-Steagall Act (repeated in 1999)

Disadvantages Higher consumer charges Decreased efficiency

Macroprudential Vs. Microprudential Supervision

Before the global financial crisis, the regulatory authorities engaged in microprudential supervision, which is focused on the safety and soundness of individual financial institutions.

The global financial crisis has made it clear that there is a need for macroprudential supervision, which focuses on the safety and soundness of the financial system in the aggregate.

The Dodd-Frank Bill and Future Regulation

The system of financial regulation is undergoing dramatic changes after the global financial crisis

Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010: The most comprehensive financial reform legislation since the Great Depression

The Dodd-Frank Bill and Future Regulation (cont’d)

The Dodd-Frank Bill addresses 5 different categories of regulation: Consumer Protection  Resolution Authority  Systemic Risk Regulation – Systemically important

financial institutions – 19 CCAR banks  Volcker Rule – banks limited on proprietary trading.  Derivatives – limits OTC transactions must be

traded on exchanges and cleared through clearing houses to reduce the risk of one counterparty going bankrupt ( Use of Margin Calls).

Four Suggested Effective Stress Testing Principals

Principal 1: A banking organization’s stress testing framework include activities and exercises that are tailored to and sufficiently capture the banking organization’s exposures, activities, and risks.

Principal 2: An effective stress testing framework should use multiple conceptually sound stress testing activities and approaches.

Principal 3: An effective stress testing framework is forward looking and flexible.

Principal 4: Stress test should be clear, actionable, well supported and inform decision making.

Stressed Scenario View

Small Loss Attacks Profits

Medium Loss Dips into Retained Earnings

Large Loss Attacks ALLL

Major Loss Wipes out Economic Capital

Erodes Excess Capital Encroaching

Into DebtExpected Loss Economic Capital

Loss DistributionLoss Buffers

Stressed Losses

$ Losses

Freq

uenc

y

Stress Test should reflect losses that impact ALLL and Excess Capital

99.9% Confidence Level

Four Basic Stress Testing Approaches

Sensitivity Analysis - refers to the assessment of exposures, activities, and risks when certain variables, parameters, and inputs are “stressed” or “shocked.”

Scenario Analysis - is a type of stress testing which a banking organization applies historical or hypothetical scenarios to assess the impact of various events including extreme ones.

Reverse Stress Testing – is a tool that allows a banking organization to assume a known adverse outcome, such as suffering a credit loss that breaches a regulatory ratio, and then deducing the types of events that could lead to that outcome.

Enterprise-wide Stress Testing – involves assessing the impact of certain specific scenarios to the banking organization as a whole, particularly on capital and liquidity.

Four Basic Stress Testing Approaches

Source Price Waterhouse Coopers