Chapter 14 1

Chapter 14. Net Noninterest Income, Operational Risk, Securitization, and Derivatives

Activities Learning Objectives:

To understand a bank's net noninterest income ("burden") and operational risk

To understand the process of securitization and its net benefits

To understand banks' derivatives activities and domination by the five largest U.S. banks

Chapter 14 2

Chapter Theme Although securitization and

derivatives activities capture two important aspects of modern banking, banks have been doing traditional off-balance sheet activities (OBSAs) such as loan commitments and lines of credit for centuries.

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Theme (continued) Banks face pressure, especially the

largest ones, to generate fee or noninterest income, to reduce noninterest or operating expenses, and to improve capital adequacy. In the context of the return-on-equity model, the competitive and regulatory pressures on both ROA and EM reflect, in part, these forces of change.

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Theme (continued) These pressures get bankers' attention

because they affect two pillars of bank performance: profitability (ROA) and capital adequacy (EM). On balance, OBSAs (including the selling of risk-management services) present banks with opportunities to strengthen customer relationships and to reduce the probability of financial distress for client firms, thereby reducing the bank's risk exposure to these customers.

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Theme (concluded) While net interest income and net interest

margin (NIM) capture the intermediation aspect of a bank's business, net noninterest income ("burden") reflects the nonintermediation and operational aspects of a bank's business. Operational risk refers to the risk of loss that banks and other financial institutions face from catastrophic events, human error, and other unpredictable happenings, e.g., the collapse of Barings, a UK investment bank.

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Motives for OBSAs Think of the ROE model

ROE = ROA x EM All other things being equal (ceteris

paribus), OBSAs can increase ROA without adding leverage to the balance sheet

Effective risk-based capital requirements, however, price the risk of OBSAs and restrict opportunities for regulatory capital arbitrage

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Net Noninterest Income (“Burden”) Net noninterest income is the

difference between noninterest income and noninterest income

For almost all banks, this measure is less than zero – hence, it is a bank’s “burden”

Fee income and operating efficiency are the focal variables

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Net Noninterest Income by Bank Size (1999) Size class % of assets Change* Top ten -0.90 38 11-100 -0.78 88 101-1,000 -1.39 62 All others -2.28 20 All banks -1.11 72 *Change since 1990 in basis points

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The Components of Noninterest (Fee) Income Services charges on deposits Income from trust activities Trading income

The 100 largest banks, especially the 10 largest, dominate this business activity

Other (noninterest) income

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Insights from the Second Stage of the ROE Model ROA = PM x AU Data for all banks:

1985: ROA = 0.0640 x 0.1084 = 0.0069 1999: ROA = 0.1556 x 0.0942 = 0.0131

ROA almost doubled over this period. Why? How?

PM surged while AU dropped slightly

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Further Insights The components of PM and AU are

three: Profits or net income “Sales” (interest income +

noninterest income) Assets

Think of the growth rates for these three variables

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Further Insights (continued) For PM to increase, the growth of NI

> the growth rate of sales For AU to decline, the growth of

sales < the growth of assets On balance, g(NI) > g(A) > g(sales) After improvement in loan quality,

the rapid growth o NI traces to noninterest income (see Table 14-1, p. 471)

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Operating Efficiency and Noninterest Expense The components of noninterest

expense: Salaries, wages, and employee benefits Expense of premises and fixed assets Other noninterest expense

Data for 1999 (% of assets), respectively, are: 1.59, 0.48, and 1.70 (3.77 total up from 3.49 for 1990)

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Noninterest Expense by Bank Size (1999) Size class % of assets Top ten 3.45 11-100 4.15 101-1,000 3.70 All others 3.71 All banks 3.77

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Operational Risk Management: The Next Frontier (Box 14-1) It is the uncertainty associated with direct

or indirect losses from inadequate or failed internal systems, processes, or people or from external events (e.g., 11 Sept. 2001)

It has become a discipline unto itself with its own management structure, processes, and tools

The Basel Committee plans to include a capital charge of operational risk for large international banks

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Why Focus on Operational Risk? Concern about losses due to ineffective

operations Regulators concerns about operational

risk Increased operational risk associated

with globalization Growing attention on enterprise-wide risk

management (holistic approach) Threat of terrorism

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September 11, 2001 and Catastrophic Risk The banks and securities firms

affected by this dastardly act had secondary and tertiary backup systems

Although backing up personnel can’t be done on a large scale, geographic diversification would reduce concentration risk

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Risk Removal Techniques: Securitization and Loan Participations

Loan participations The traditional method achieved by using

loan syndications Credit of $50 million or more are regarded

as syndicated loans Large syndications have 100 or more banks

participating (see Box 14-2 on page 477 for the major players)

Almost $2 trillion in syndicated loans at year-end 2000

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The Modern Approach: Securitization John Reed said: “Securitization is the

substitution of more efficient public capital markets for less efficient, higher cost financial intermediaries in the funding of debt instruments.”

Good news: Several benefits (next slide) Bad news: Threatens existence of

traditional intermediaries

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The Benefits of Securitization Increased liquidity from the ability

to sell assets Enhanced revenue/profits from

asset sales Increased servicing income Conservation of capital

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Understanding the Process of Securitization Five basic parties:

1. Loan originator (bank) 2. Loan purchaser (affiliated trust) 3. Loan packager (underwriter of the

securities) 4. Credit enhancer (guarantor) 5. Investors (individuals and banks)

Table 14-2 and Figure 14-1 (pp. 479-480) summarize the process in terms of the structure of deals and cash flows

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Terminology Asset-backed securities

The underlying loans represent the cash flows that stand behind and give value to asset-backed securities

Mortgage-backed securities – securitization began with these instruments and spread such that the modern banker’s calling card reads: “Have Loans, Will Securitize” (see Table 14-3, p. 481)

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Terminology (continued) Pass-through securities are not

collateralized or secured by “hard assets” but are backed by unsecured credits such as credit-card receivables (Some confusion exists here because the cash flows “pass through” whether the underlying asset is “hard” or “soft”)

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Terminology (continued) Collateralized debt obligations

(CDOs) Two main sources of underlying assets

or collateral are: loans (CLOs) and bonds (CBOs)

A CDO has a legal structure called a special-purpose vehicle (SPV) set up as a subsidiary of a holding company – view it as a balance sheet

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Terminology (continued) Collateralized-loan obligations (CLOs)

In a traditional CLO, the originating bank physically transfers the loan portfolio to the SPV, which issues the securities backed by the underlying loans

In a synthetic CLO, the assets are not physically transferred and a credit derivative (see Chapter 11) transfer the credit risk of the collateral to the SPV

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Terminology (continued) Three kinds of synthetic CLOs exist:

1. Fully funded in which all the credit risk transfers to the SPV

2. Partially funded in which part of the credit risk is transferred to the SPV

3. Unfunded in which none of the credit risk transfers to the SPV – the transfer is achieved with a credit derivative

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Securitization: A Two-Way Street It’s a risk-removal technique Use it to add assets and risk to an

existing balance sheet

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Value-Added Through Securitization (Table 14-3) Underlying asset Securitized Asset Illiquid Liquid Weak valuation Market values Lender monitoring Third party

monitors Higher oper exp Lower oper exp Product limits Wider offerings Limited market Broader market

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Derivatives: Hedging, Speculating, Selling Risk-Management Services Two basic kinds of derivatives:

1. Futures and forwards (linear contracts) 2. Options (nonlinear contracts)

Value based on or “derived” from the underlying which can be an interest rate, exchange rate, equity return, or a commodity price

Trading: Exchange versus OTC As a hedging tool, see Box 14-3 (p. 487)

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Derivative Securities Three classes:

1. Structured securities and deposits (e.g., duel-currency bonds)

2. Stripped securities (e.g., IOs and POs) 3. Securities with option characteristics

(e.g., callable bonds) See Table 14-5 (p. 485) for additional

examples of derivative securities)

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Discussions Topics Bankers Trust and Derivatives

Liability Who dominates the world of

derivatives and why? Are derivatives the basic business of

banking? Have derivatives fundamentally

changed financial management? A framework for risk management

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The Risk of Derivatives Activities IS MORC ILL? (see Table 14-6, p.

491) These nine risks can be condensed

into four broad risk categories 1. Market risk 2. Credit risk 3. Liquidity risk 4. Operational and legal risk

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Measuring Risk Exposure Notional value is not a good measure Credit-equivalent exposure is the

sum of 1. Bilaterally netted current credit

exposure 2. Future exposure

Glossary (Box 14-4, p, 493) Data (Table 14-7, 14-8, 14-9, pp.

494-497)

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Transparency and Disclosure Bank loans and OTC derivatives

share three common characteristics: 1. Customized 2. Privately negotiated 3. Often lack liquidity and transparency

Result: They are more difficult to value and manage

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The Regulatory Dialectic (Struggle Model) Thesis: Derivatives and

securitization Antithesis: Risk-based capital

requirements for these activities Synthesis: Regulatory capital

arbitrage seeks ways to circumvent requirements

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Chapter Summary Asset securitization and

derivatives activities capture two of the traits of modern banking

Although the world of derivatives is dominated by large banks, securitization has a much broader appeal