FINANCIAL MARKETS AND INSTITIUTIONS: A Modern …scarbo/GBQF.ppt · PPT file · Web view- SINKEY, J. (2001): COMMERCIAL BANK ... Payment card service companies ... (Asset transformers)

GESTIN BANCARIA

Master en Banca y Finanzas Cuantitativas (QF), 2008

Santiago Carb Valverde

Universidad de Granada

Santiago Carb Valverde

Universidad de Granada

[email protected]

Materiales docentes en:

http://www.ugr.es/~scarbo/MASTERQF08.html

Esquema de trabajo:Transparencias en inglsPresentaciones de papers en claseExamen final

Referencia bsica:

- SAUNDERS, A. Y M.M. CORNETT (2000): FINANCIAL INSTITUTIONS MANAGEMENT: A MODERN PERSPECTIVE, 4 EDICIN, MCGRAW HILL, NEW YORK, ESTADOS UNIDOS.

- SINKEY, J. (2001): COMMERCIAL BANK FINANCIAL MANAGEMENT, SEXTA EDICIN, PRENTICE HALL, NEW YORK, ESTADOS UNIDOS.

Tema 1

LA INDUSTRIA DE SERVICIOS FINANCIEROS: LAS ENTIDADES DE DEPSITO

(LECTURA DE REFERENCIA: BHATTACHARYA Y THAKOR, 1993)

Why study Financial Markets and Institutions?

They are the cornerstones of the overall financial system in which financial managers operateIndividuals use both for investingCorporations and governments use both for financing

Overview of Financial Markets

Primary Markets versus Secondary MarketsMoney Markets versus Capital MarketsForeign Exchange Markets

Primary Markets versus Secondary Markets

Primary Marketsmarkets in which users of funds (e.g. corporations, governments) raise funds by issuing financial instruments (e.g. stocks and bonds)Secondary Marketsmarkets where financial instruments are traded among investors (e.g. Bolsa Madrid, NYSE, NASDAQ)

Money Markets versus Capital Markets

Money Marketsmarkets that trade debt securities with maturities of one year or less (e.g. Spanish Government bonds, U.S. Treasury bills)Capital Marketsmarkets that trade debt (bonds) and equity (stock) instruments with maturities of more than one year

Money Market Instruments Outstanding, 1990-1999 ($Bn)

Capital Market Instruments Outstanding, 1990-1999 ($Bn)

Foreign Exchange Markets

FX markets deal in trading one currency for another (e.g. dollar for yen)The spot FX transaction involves the immediate exchange of currencies at the current exchange rateThe forward FX transaction involves the exchange of currencies at a specified date in the future and at a specified exchange rate

Overview of Financial Institutions (FIs)

Institutions that perform the essential function of channeling funds from those with surplus funds to those with shortages of funds (e.g. banks, thrifts, insurance companies, securities firms and investment banks, finance companies, mutual funds, pension funds)

Flow of Funds in a World without FIs: Direct Transfer

Users of Funds

(Corporations)

Suppliers of Funds

(Households)

Financial Claims

(Equity and debt instruments)

Cash

Example: A firm sells shares directly to investors without going

through a financial institution

Flow of Funds in a world with FIs: Indirect transfer

Users of Funds

FI

(Brokers)

FI

(Asset

transformers)

Suppliers of Funds

Financial Claims

(Equity and debt securities)

Financial Claims

(Deposits and Insurance policies)

Types of FIs

Commercial banksdepository institutions whose major assets are loans and major liabilities are depositsThrifts and savings banksdepository institutions in the form of savings banks, savings and loans, credit unions, credit cooperativesInsurance companiesfinancial institutions that protect individuals and corporations from adverse events

(continued)

Securities firms and investment banksfinancial institutions that underwrite securities and engage in securities brokerage and tradingFinance companiesfinancial institutions that make loans to individuals and businessesMutual Fundsfinancial institutions that pool financial resources and invest in diversified portfoliosPension Fundsfinancial institutions that offer savings plans for retirement

Services Performed by Financial Intermediaries

Monitoring Costsaggregation of funds provides greater incentive to collect a firms information and monitor actionsLiquidity and Price Riskprovide financial claims to savers with superior liquidity and lower price risk

(continued)

Transaction Cost Servicestransaction costs are reduced through economies of scaleMaturity Intermediationgreater ability to bear risk of mismatching maturities of assets and liabilitiesDenomination Intermediationallow small investors to overcome constraints imposed to buying assets imposed by large minimum denomination size

Services Provided by FIs Benefiting the Overall Economy

Money Supply TransmissionDepository institutions are the conduit through which monetary policy actions impact the economy in generalCredit Allocationoften viewed as the major source of financing for a particular sector of the economy (e.g. farming and real estate)

(continued)

Intergenerational Wealth Transferslife insurance companies and pension funds provide savers with the ability to transfer wealth from one generation to the nextPayment Servicesefficiency with which depository institutions provide payment services directly benefits the economy

Services Provided by FIs Benefiting

the Overall Economy

Risks Faced by Financial Institutions

Interest Rate RiskForeign Exchange RiskMarket RiskCredit RiskLiquidity RiskOff-Balance-Sheet RiskTechnology RiskOperation RiskCountry or Sovereign RiskInsolvency Risk

Regulation of Financial Institutions

FIs provide vital financial services to all sectors of the economy; therefore, their regulation is in the public interestIn an attempt to prevent their failure and the failure of financial markets overall

Globalization of Financial Markets and Institutions

Financial Markets became more global as the value of stocks traded in foreign markets soaredForeign bond markets have served as a major source of international capitalGlobalization also evident in the derivative securities market

Factors Leading to Significant Growth in Foreign Markets

The pool of savings from foreign investors has increasedInternational investors have turned to U.S. and other markets to expand their investment opportunitiesInformation on foreign investments and markets is now more accessible (e.g. internet)Some mutual funds allow ability to invest in foreign securities with low transaction costsDeregulation has enhanced globalization of capital flows

Tema 2

POR QU SON ESPECIALES LOS INTERMEDIARIOS BANCARIOS?

(LECTURA DE REFERENCIA: ALLEN Y SANTOMERO (1997)

Why Are Financial Intermediaries Special?

Objectives:Develop the tools needed to measure and manage the risks of FIs.Explain the special role of FIs in the financial system and the functions they provide.Explain why the various FIs receive special regulatory attention.Discuss what makes some FIs more special than others.

Without FIs

Corporations

(net borrowers)

FIs Specialness

Without FIs: Low level of fund flows.Information costs:Economies of scale reduce costs for FIs to screen and monitor borrowers Less liquiditySubstantial price risk

With FIs

Financial Structure Puzzles: a way to explain the role of FIs

stocks are not the most important source of external financing for businesses

issuing debt and equity is not the main way that businesses finance operations

indirect financing is more important than direct financing

banks are the most important source of external funds for businesses

financial industry is one of the most heavily regulated industries

only large, well-known firms have access to the securities markets

collateral is an important part of debt contracts for businesses and households

debt contracts are complex and often contain many restrictions for the borrower

Transaction Costs

information and other transaction costs in financial system can be substantial

How do transaction costs affect investing?

How can financial intermediaries reduce transaction costs?

Asymmetric Information

one party to a transaction has better information to make decisions than the other party

asymmetric information in financial market causes two main problems

adverse selection

moral hazard

Adverse Selection

asymmetric information problem that occurs prior to a transaction

examples of adverse selection

result of adverse selection is that lenders may decide not to make loans if they can not distinguish between good and bad credit risks

Moral Hazard

asymmetric information problem that occurs after a transaction

risk that borrower will undertake risky activities that will increase the probability of default

result of moral hazard is that lenders may decide not to make a loan

Lemons Problem

idea presented in article by George Akerlof in terms of lemons in used car market

used car buyers are unable to determine quality of car - good car or lemon?

What amount is buyer willing to pay for this used car of unknown quality?

How can buyer improve information on quality?

Lemons Problem in Stock and Bond Market

asymmetric information prevents investors from identifying good and bad firms

What price will these investors pay for stock?

Who has better information about the firm?

Which firms will come to the market for financing under these conditions?

Principal-Agent Problem

define the principal-agent problem

Who is the principal and who is the agent?

What problem does a separation of ownership and control cause?

How could we prevent principal-agent problem?

Solutions to Financing Puzzles

lemons or adverse selection problem tells why marketable securities are not the primary source of financing

situation is similar in corporate bond market

tells why stocks are not the most important source of external financing

More Solutions to Financial Structure Puzzles

importance of financial intermediaries explains importance of indirect financing

explains why banks are most important source of external financing

explains why markets are only available to large, well-known firms

Functions of FIs

Brokerage functionActing as an agent for investors:e.g. Merrill Lynch, Charles SchwabReduce costs through economies of scaleEncourages higher rate of savingsAsset transformer:Purchase primary securities by selling financial claims to householdsThese secondary securities often more marketable

Role of FIs in Cost Reduction

Information costs:Investors exposed to Agency CostsRole of FI as Delegated Monitor (Diamond, 1984)Shorter term debt contracts easier to monitor than bondsFI likely to have informational advantage

Services Performed by FIs

Monitoring CostsLiquidity and Price RiskTransaction Cost ServicesMaturity IntermediationDenomination Intermediation

Services Provided by FIs

Money Supply TransmissionCredit AllocationIntergenerational Wealth TransfersPayment Services

(continued)

Regulation of FIs

Regulation is not costlessNet regulatory burden.Safety and soundness regulationMonetary policy regulationCredit allocation regulationConsumer protection regulationInvestor protection regulationEntry regulation

Changing Dynamics of Specialness

Trends in the United StatesDecline in share of depository institutions.Increases in pension funds and investment companies.May be attributable to net regulatory burden imposed on depository FIs.Technological changes affect delivery of financial services and regulatory issuesPotential for regulations to be extended to hedge fundsResult of Long Term Capital Management disaster

Future Trends

Weakening of public trust and confidence in FIs may encourage disintermediationIncreased merger activity within and across sectorsCiticorp and Travelers, UBS and Paine WebberMore large scale mergers such as J.P. Morgan and Chase, and Bank One and First ChicagoGrowth in Online TradingIncreased competition from foreign FIs at home and abroadMergers involving worlds largest banksMergers blending together previously separate financial services sectors

Tema 3

ORGANIZACIN INDUSTRIAL DEL SECTOR BANCARIO

(LECTURA DE REFERENCIA: HUMPHREY ET AL. (2006))

3. Bank competition

3.1. BANK COMPETITION

THE STRUCTURE-CONDUCT-PERFORMANACE (SCP) PARADIGM: Many empirical studies have considered concentration - mainly the Herfindahl-Hirschman Index (HHI) - as a proxy for bank market power following the Structure-Conduct-Performance (SCP) paradigm (Berger and Hannan, 1989; Hannan and Berger, 1991).

However, several contributions to the banking literature during the last two decades have cast doubt on the consistency and robustness of concentration as an indicator of market power (Berger, 1995; Rhoades, 1995; Jackson 1997; Hannan, 1997).

IO theory predicts a correspondence between the Lerner index (L) as the spread between prices (P) and marginal costs (C) divided by prices - and the HHI so that , where is a conjecture parameter showing the response of the industry output to changes to a unit output change by the firm, and is the industry price elasticity of demand. If =1 there is a monopoly solution while if =0, then a Bertrand solution holds with L=0.

Hence, the correspondence depends upon restrictive assumptions on the conjecture and demand elasticity parameters.

As contestability increases in a market, the reliability of the HHI as a measure of market power is significantly limited.

Therefore, changes in the stability of the banking sector as a consequence of industry restructuring or liberalization may cast doubt on the validity of the HHI as a dynamic measure of competition. Instability will also affect conjecture and elasticity parameter so that the relationship between market power and concentration becomes blurred.

Although the SCP hypothesis of a positive relationship between concentration and profits can be derived from oligopoly theory under these assumptions of different solutions to a Cournot model, it is not warranted under alternative models.

Some empirical studies have even tested and rejected the hypothesis of Cournot conduct in the banking industry (Roberts, 1984; Berg and Kim, 1994). Econometric developments have permitted the emergence of empirical papers from the so-called New Empirical Industrial Organization (NEIO) perspective, by directly estimating the parameters of a firm's behavioral equation and, in particular, marginal costs - to directly obtain indicators such as the Lerner Index (Schmalensee, 1989).

Although price to marginal costs indicators are not new from a theoretical standpoint, marginal costs have only been econometrically estimated during the last two decades. Applications to the banking industry as in Shaffer (1993), Ribon and Yosha (1999) or Maudos and Fernndez de Guevara (2004) have already shown that these price to marginal costs indicators are frequently uncorrelated with concentration ratios.

The definition of the mark-up and the Lerner index can be directly derived from a simplified market structure model (Bresnahan, 1989) where banking firms are supposed to produce a single good.

Assuming that banks behave as profit maximizers, the general expression for intermediate oligopolistic market structures with m banks operating in the market is expressed as:

where p is the price of the bank product; C(yj, wj) is a cost function defined for each bank j where yj is the quantity produced by firm j in the industry and wj represents the vector of prices of the factors of bank j. The parameter j expresses the degree of market power from perfectly competitive (j = 0) to monopolist (j = 1). This can be alternatively written as:

where the mark-up of price over marginal cost ([p C(yj, wj)]) equals the inverse of the semi-elasticity on bank product demand (1/) times the market structure parameter (j). Therefore, higher values of the mark-up measure will indicate a worsening of bank competition conditions either by a decrease in the semi-elasticity of demand on bank product () or an increase in the market structure parameter (j).

The mark-up is used to compute the Lerner index, which is a relative margin computed as [p C(yj, wj)] / p. Higher values of the Lerner index also indicate a worsening of competition conditions.

3.2. BANK EFFICIENCY: AN APPLICATION TO THE SPANISH CASE

Previous Cost Efficiency Results in Banking

The average bank experiences total (operating + interest) costs that are 20 to 25% higher than the most cost efficient bank.

This is the conclusion of many individual studies as well as the average result from 130 studies across 21 countries for 5 different frontier cost approaches.

Bank net income is from 15 to 20% of total costs. Thus the average bank could more than double its profits/ROA if it achieved frontier efficiency or "best practice".

Yet, cost efficiency seems relatively stable over time and

seemingly beyond the control of management.

Efforts to "explain" both the level of cost efficiency and its apparent stability over time have not be very successful.

Almost all explanatory analyses have so far focused on balance sheet "causes" or associations with measured inefficiency. Fixed effects models (dummy variables) do better but do not identify the causes.

The few studies that have looked at banks' external business environment have been more successful.

(Berger & Mester, 1997; Dietsch & Lozano Vivas, 2000)

NEW EVIDENCE: A three-part Approach to Cost Efficiency (a recent paper by Carbo, Humphrey and Lopez)

Explain efficiency differences using information on:

1. A bank's external business environment (following

Berger & Mester, 1997; Dietsch & Lozano Vivas, 2000);

2. A bank's technical ability to combine inputs into outputs

using a cost function specification--the standard approach;

3. A bank's internal productivity, using common peer group

indicators to decompose remaining measured inefficiency.

As expect operating cost to reflect most efficiency differences, we separate operating from interest costs.

Estimation Approach

Parametric Model (Cost Function):

Distribution-Free approach to efficiency measurement--assumes random errors estimated for each individual bank over 10 years averages to zero, leaving an unexplained "inefficiency" residual (Ui).

Bank with the smallest inefficiency residual (Umin) is on the cost frontier. Efficiency is measured as: EFF = Umin/Ui.

If Umin/Ui = .80, resources used at most efficient bank are only 80% of those used at bank i. Inefficiency at bank i is (1 - .8)/.8 = 25%.

Estimation Approach

Parametric Model (Cost Function):

As Fourier and translog cost functions give same initial results, report parametric results using the simpler translog cost model.

Non-Parametric Model (Linear Programming):

Data Envelopment Analysis (DEA) determines bank that produces a given output vector with minimum input cost.

As assume random error is zero, can determine EFF for each year.

Ensuring Comparability

Parametric Model: Distribution-Free approach represents average EFF over 10 years. Thus report DEA results as a 10-year average.

Non-Parametric Model: DEA approach does not truncate "extreme" EFF values. Thus report untruncated Distribution-Free results.

(Truncation raises efficiency values. Is used because assumption that error for each bank averages to zero is likely too strong to be met.)

Efficiency of Spanish Banks (Cost Function Only)

Average Efficiency Estimates: 1992-2001 (1,540 panel obs.)

Parametric EFF = 85%(18% unexplained inefficiency)

R2 = .995

| Ui |/total cost = 5%

Non-Parametric EFF = 87%(16% unexplained inefficiency)

Other Spain

82% (Lozano, Pastor, & Pastor, 2002)

Estimates:

87% (Maudos & Pastor, 2003)

Efficiency of Spanish Banks

Almost all efficiency studies stop here. Some go on to regress

EFF values on various balance sheet "influences".

Low R2s (e.g., .10) are the typical result, so actual causes of inefficiency remain largely unexplained.

Inefficiency usually attributed to typically unspecified:

Managerial policies & procedures

Organizational structure

Leadership ability

Information On A Bank's External Business Environment

A. Interest Cost Equation:

3-month interest rate (affects funding costs)

B. Operating Cost Equation:

Average regional wage (influences labor costs)

Property cost index (affects branch costs)

C. Both Equations:

Asset size (not easily changed in short-run, mergers excepted)

Regional GDP (loan demand & deposit supply)

Asset market share (market power indicator)

Regional location (rural versus city areas & income level)

(translog formulation: own, cross, and squared terms)

Information On A Bank's Technical Ability To Combine

Inputs Into Outputs (A Cost Function Specification)

A. Interest Cost Equation (1 input price):

Average cost of funding

B. Operating Cost Equation (3 input prices):

Average bank wage

Depreciation/value of physical capital

Opportunity cost of funds spent on material inputs

C. Both Equations (2 banking "outputs"):

Value of loans & value of security holdings

(will add value of off-balance-sheet activities later).


Information On A Bank's Internal Productivity

Using Common Peer Group Indicators

A. Interest Cost Equation:

Deposit/total asset ratio (higher ratio, lower funding cost)

B. Operating Cost Equation:

Number of ATMs (low cost way to deliver services)

Number of branches (high cost way to deliver services)

Labor/branch ratio (branch productivity indicator)

Deposit/branch ratio (branch productivity indicator)

C. Both Equations:

ATM/Branch ratio (more convenience, pay lower deposit rate)

Loan/total asset ratio (higher ratio, can pay higher deposit rate)


Table 1: Bank Interest Cost Efficiency--DFA, 1992-2001

Interest Cost Equation:

EFF

INEFF

% Unexplained

External Influences

.69

.45

10.5%

Technical Influences

.91

.10

2.2%

External+Technical

.922

.085

1.93%

External+Technical+Internal

.989

.011

0.16%

Savings Banks:


.999

.001

0.04%

Commercial Banks:


.993

.007

0.17%

Table 2: Bank Operating Cost Efficiency--DFA, 1992-2001

Operating Cost Equation:

EFF

INEFF

% Unexplained

External Influences

.52

.92

13.2%


.65

.54

12.0%

Internal Influences

.67

.49

15.3%

External+Technical

.72

.39

8.6%


.89

.12

4.3%

Savings Banks:


.94

.06

1.9%

Commercial Banks:


.96

.04

1.6%

Table 3: Bank Interest Cost Efficiency--DEA, 1992-2001

Interest Cost Equation:

EFF

INEFF


.83

.20

External+Technical

.92

.09


.93

.08

Savings Banks:


.97

.03

Commercial Banks:


.92

.09

Table 4: Bank Operating Cost Efficiency--DEA, 1992-2001

Operating Cost Equation:

EFF

INEFF


.95

.05

External+Technical

.96

.04


.98

.02

Savings Banks:


.98

.02

Commercial Banks:


.99

.01

Results So Far

External, Technical, and Internal variables together explain

almost all bank cost efficiency differences for Spain.

Internal/productivity influences, not balance sheet variables,

identify source of cost inefficiency.

Parameter signs show that operating cost falls and efficiency

rises when:

Deliver services using more ATMs vs. branches;

Each branch generates more deposits with less labor.

(The "black box" was never black, just not fully specified.)

Results So Far

Earlier studies have found EFF to be relatively stable over time.

The DEA results of this new paper are also relatively stable by year (not shown).

Now look at time-series (mean) vs. cross-section (dispersion)

changes in unit operating cost (OC/TA).

Why? Because ATM/branch tradeoff and other productivity

indicators explain both cross-section OC efficiency differences

and the observed time-series reduction in OC.

Introduccin

Existen, al menos, tres dimensiones en las que se precisan avances para lograr un diagnstico ms preciso de la realidad competitiva de la industria bancaria de la UE y poder arbitrar polticas acordes con los objetivos de integracin y la mejora del acceso a los servicios bancarios

Tema 4

GOBIERNO Y ESTRUCTURA ORGANIZATIVA DE LA BANCA

(MATERIAL DEL PROFESOR)

It is the ability to foretell what is going to happen tomorrow, next week, next month, and next year. And to have the ability afterwards to explain why it didnt happen.

Sir Winston Churchill

What are Financial Intermediaries (FIs)?

Financial Securities: contingent claims on future cash flows debt, equity, derivatives, hybrids. All firms liabilities & net worth are predominately comprised of financial securities.But most firms hold real assets such as inventory, plant & equipment, buildings.FIs assets are predominately comprised of financial securities.

Transparent, Transluscent and Opaque FIs

46.bin

What Services Do FIs Provide?

InformationLiquidityReduced Transaction CostsTransmission of Monetary PolicyCredit AllocationPayment ServicesIntergenerational Wealth Transfer

FIs are the most regulated of all firms

Safety and Soundness RegulationDeposit InsuranceMonetary Policy RegulationReserve RequirementsCredit Allocation Regulation (eg., mortgages)Consumer Protection RegulationCommunity Reinvestment Act, Home Mortgage Disclosure Act, Truth in Lending ProtectionInvestor Protection RegulationEntry Regulation

Types of FIs

Depository InstitutionsInsurance CompaniesSecurities Firms and Investment BanksMutual FundsFinance CompaniesDistinctions blurred by the Gramm-Leach-Bliley Act of 1999 that created Financial Holding Companies (FHCs).

Features Common to Most FIs

High Amount of Financial LeverageLow equity/assets ratios. Capital requirements.Off-balance sheet items Contingent claims that under certain circumstances may eventually become balance sheet items (ex. Derivatives, commitments)Revenue: Interest Income & Fees Costs: Interest Expenses and Personnel

Depository Institutions

Commercial Banks: accept deposits and make loans to consumers and businesses.Money Center Banks: Citigroup, Bank of NY, BankOne, Bankers Trust (Deutschebank), JP Morgan Chase and HSBC Bank USA.Savings Associations (S&Ls)Qualified Thrift Lender (QTL) mortgages must exceed 65% of thrifts assets.Savings BanksUse deposits to fund mortgages & other assets.Credit Unions and Credit cooperativesNonprofit mutually owned institutions (owned by depositors).

Overview of Depository Institutions

In this segment, we explore the depository FIs:Size, structure and compositionBalance sheets and recent trendsRegulation of depository institutionsDepository institutions performance

Products of FIs

Comparing the products of FIs in 1950, to products of FIs in 2003:Much greater distinction between types of FIs in terms of products in 1950 than in 2003Blurring of product lines and services over timeWider array of services offered by all FI types

Specialness of Depository FIs

Products on both sides of the balance sheetLoansBusiness and CommercialDeposits

Other outputs of depository FIs

Other products and services 1950:Payment services, Savings products, Fiduciary servicesBy 2003, products and services further expanded to include:Underwriting of debt and equity, Insurance and risk management products

Size of Depository FIs

Consolidation has created some very large FIsCombined effects of disintermediation, global competition, regulatory changes, technological developments, competition across different types of FIs

Largest Depository Institutions in the US

Citigroup$1,208.9

J.P. Morgan Chase* 770.9

Bank of America** 736.4

Wells Fargo 393.9

Wachovia 388.0

Bank One* 326.6

Washington Mutual 275.2

Fleet Boston** 200.2

U.S. Bancorp 188.8

SunTrust Banks 181.0

Total Assets ($Billions)

Organization of Depository Institutions

Commercial BanksLargest depository institutions are commercial banks.Differences in operating characteristics and profitability across size classes.Notable differences in ROE and ROA as well as the spreadThriftsS&LsSavings BanksCredit UnionsMix of very large banks with very small banks

Functions & Structural Differences

Functions of depository institutionsRegulatory sources of differences across types of depository institutions.Structural changes generally resulted from changes in regulatory policy.Example: changes permitting interstate branchingReigle-Neal Act (1994) in the USIn Spain, deregulation in 1989 concerning savings banks operations

Commercial Banks

Primary assets:Real Estate Loans: $2,272.3 billionC&I loans: $870.6 billionLoans to individuals: $770.5 billionInvestment security portfolio: $1,789.3 billionOf which, Treasury bonds: $1,005.8 billionInference: Importance of Credit Risk

Commercial Banks

Primary liabilities:Deposits: $5,028.9 billionBorrowings: $1,643.3 billionOther liabilities: $238.2 billionInference:Highly leveraged

Small Banks, US

Chart1

14

1

8

14

63

Sheet1

Small Banks, Nation

C&I14

Credit Card1

Consumer8

Other14

Real Estate63

Sheet2

Sheet3

Large Banks, US

Chart1

18

7

10

21

44

Sheet1

Small Banks, Nation

C&I18

Credit Card7

Consumer10

Other21

Real Estate44

Sheet2

Sheet3

Structure and Composition

Shrinking number of banks:14,416 commercial banks in 198512,744 in 19897,769 in 2004Mostly the result of Mergers and AcquisitionsM&A prevented prior to 1980s, 1990sConsolidation has reduced asset share of small banks

Structure & Composition of Commercial Banks

Financial Services Modernization Act 1999Allowed full authority to enter investment banking (and insurance)Limited powers to underwrite corporate securities have existed only since 1987

Composition of Commercial Banking Sector

Community banksRegional and Super-regionalAccess to federal funds market to finance their lending activitiesMoney Center banksBank of New York, Deutsche Bank (Bankers Trust), Citigroup, J.P. Morgan Chase, HSBC Bank USAdeclining in number

Balance Sheet and Trends

Business loans have declined in importanceOffsetting increase in securities and mortgagesIncreased importance of funding via commercial paper marketSecuritization of mortgage loans

Some Terminology

Transaction accountsNegotiable Order of Withdrawal (NOW) accounts (cuenta a la vista)Money Market Mutual FundNegotiable CDs (certificados de depsito): Fixed-maturity interest bearing deposits with face values over $100,000 that can be resold in the secondary market.

Off-balance Sheet Activities

Heightened importance of off-balance sheet itemsLarge increase in derivatives positions is a major issueStandby letters of creditLoan commitmentsWhen-issued securitiesLoans sold

Trading and Other Risks

Allied Irish / Allfirst Bank $750 million loss (2001)National Australian Bank $450 million loss (2004)

Failure of the U.K. investment bank Barings

The Bankruptcy of Orange County in California.

Other Fee-generating Activities

Trust servicesCorrespondent bankingCheck clearingForeign exchange tradingHedgingParticipation in large loan and security issuancesPayment usually in terms of noninterest bearing deposits

Key Regulatory Agencies

FDIC and the Office of the Comprotroller of the Currency in the US.European Central BankNational central banksNational GovernmentsRegional Governments

Web Resources

For more detailed information on the regulators, visit:

http://www.ecb.int

http://www.bde.es

http://www.fdic.gov

http://www.occ.treas.gov

http://federalreserve.gov

Banking and Ethics

Some cases for the US:

Bank of America and Fleet Boston Financial 2004J.P. Morgan Chase and Citigroup 2003 role in EnronRiggs National Bank and money laundering concerns 2003

Savings Institutions

Comprised of:Savings and Loans AssociationsSavings Banks

Effects of moral hazard and regulator forbearance. Quite a debate worldwhile.

Savings Institutions: Recent Trends

Industry is smaller overallIntense competition from other FIs mortgages for exampleConcern for future viability in certain countries.

Credit Unions

Nonprofit depository institutions owned by member-depositors with a common bond.Exempt from taxes and Community Reinvestment Act (CRA) in the US.Expansion of services offered in order to compete with other FIs.Very important in certain European countries (Germany, Spain).

Global Issues

Near crisis in Japanese BankingEight biggest banks reported positive six-month profitsChinaDeterioration, NPLs (nonperforming loans) at 50% levelsOpening to foreign banks (WTO entry)German bank problems in early 2000sImplications for future competitiveness

Largest Banks in the World

Tema 5

La concesin de crdito, el riesgo de crdito y otros riesgos

(LECTURA DE REFERENCIA: ALTUNBAS ET AL.,2007)

5.1. THE CONCEPT OF RISK

Risks facing all financial institutions can be segmented into three separable types, from a management perspective. These are:(i) risks that can be eliminated or avoided by simple business practices,(ii) risks that can be transferred to other participants, and,(iii) risks that must be actively managed at the firm level.

The management of the banking firm relies on a sequence of steps to implement a risk management system. These can be seen as containing the following four parts:(i) standards and reports,(ii) position limits or rules,(iii) investment guidelines or strategies,(iv) incentive contracts and compensation.

SOURCES OF RISK

For the sector as a whole, the risks can be broken into six generic types:

systematic or market risk

credit risk

counterparty risk

liquidity risk

operational risk

legal risk

Systematic risk is the risk of asset value change associated with systematic factors. It is sometimes referred to as market risk, which is in fact a somewhat imprecise term. By its nature, this risk can be hedged, but cannot be diversified completely away. In fact, systematic risk can be thought of as undiversifiable risk.

Credit risk arises from non-performance by a borrower. It may arise from either an inability or an unwillingness to perform in the pre-committed contracted manner. This can affect the lender holding the loan contract, as well as other lenders to the creditor.

Therefore, the financial condition of the borrower as well as the current value of any underlying collateral is of considerable interest to its bank

Counterparty risk comes from non-performance of a trading partner. The non-performance may arise from a counterparty's refusal to perform due to an adverse price movement caused by systematic factors, or from some other political or legal constraint that was not anticipated by the principals.

Diversification is the major tool for controlling nonsystematic counterparty risk.

Liquidity risk can best be described as the risk of a funding crisis. While some would include the need to plan for growth and unexpected expansion of credit, the risk here is seen more correctly as the potential for a funding crisis.

Such a situation would inevitably be associated with an unexpected event, such as a large charge off, loss of confidence, or a crisis of national proportion such as a currency crisis.

Operational risk is associated with the problems of accurately processing, settling, and taking or making delivery on trades in exchange for cash. It also arises in record keeping, processing system failures and compliance with various regulations.

As such, individual operating problems are small probability events for well-run organizations but they expose a firm to outcomes that may be quite costly.

Legal risks are endemic in financial contracting and are separate from the legal ramifications of credit, counterparty, and operational risks.

New statutes, tax legislation, court opinions and regulations can put formerly well-established transactions into contention even when all parties have previously performed adequately and are fully able to perform in the future.

5.2. REGULATION AND CREDIT RISK: AN EXAMPLE FROM BASEL II

Historically, regulation has limited who can:open or charter new banks and what products and services banks can offer.Imposing barriers to entry and restricting the types of activities banks can engage in clearly enhance safety and soundness, but also hinder competition.

It assumed that the markets for bank products, largely bank loans and deposits, could be protected and that other firms could not encroach upon these markets. Not surprisingly, investment banks, hybrid financial companies, insurance firms, and others found ways to provide the same products as banks across different geographic markets.

However, there is another type of regulation that has concentrated most of the attention in the last three decades, the bank capital regulation.Changes in reserve requirements directly affect the amount of legal required reserves and thus change the amount of money a bank can lend out. The main recent example is BASEL II.

THE STRATEGIC IMPACT OF BASEL II

Basel 2 is a step change in the regulation of capital adequacy. It will alter the industry frame of reference for banks in many ways: Regulators are clearly recognizing market realities and seeking a much closer congruence between regulatory and economic capital.

The new proposals are more complex and sophisticated than earlier schemes. They will also have to evolve as market conditions, technology and financial management techniques develop.

The calibration exercises that have resulted from the various Quantitative Impact Studies (QIS) are targeted (initially at least) to deliver broadly the same amount of capital as the current Accord. However, the mix of capital charges will change significantly with the wider range of risk weights and greater risk sensitivity of Basel 2.

Basel 2 will clearly be much more risk-sensitive in assigning capital charges. Mortgage lending and lending to higher quality borrowers will be incentivised under Basel 2.

It is not clear whether the present or new Basel Accord are a binding constraint on banks current credit operations. Jackson et al (2001, Bank of England WP) suggest that banks may employ more conservative capital standards than those imposed under Basel 1 or likely under Basel 2.

Compliance costs are likely to increase. Banks will have to evaluate (as a kind of capital investment decision) whether the costs (including compliance costs) of moving to the more advanced Basel 2 systems are worthwhile.

Banks will increasingly target better risk management as a source of competitive advantage. Increasingly, superior risk management will become a key success factor for those banks who are able to respond successfully to the new environment.

Nevertheless, specialist banks who focus on a smaller number of core products and services should similarly be able to obtain risk management benefits of specialization.

Basel 2 will enhance present securitisation trends in banking. This will help in its turn to emphasise further the strategic importance of investment banking. At the same time, lending bankers will face increasing adverse selection trends as the better credits are able to access directly the capital markets.

This trend will help to re-emphasise the importance of credit skills in lending banks. It will also put pressure on these banks to widen their margins (in order to achieve the higher risk premia needed to cover their more risky lending).

Governance will be an increasingly important issue in the new regime. More disclosure is not enough by itself to secure market discipline (the aim of Pillar 3). A wide collection of new and improved governance structures will be needed. These include:

a freer market in bank corporate control;good corporate governance in banks;incentive-compatible safety nets;no bail-out policies;and proper accounting standards.

Banks will be required to disclose more information than ever before to the external market. This will involve additional compliance costs. Strategically, it will reinforce any competitive advantage gained by good risk-management banks.

Under Pillar 3 and with likely changes in bank governance arrangements, the prospects of take-overs (and no bail-outs) for individual banks who are inefficient are likely to increase. This new world is a likely further threat to concepts like mutuality and subsidised (or at least protected from competition) regional banking.

Insofar as the new capital regime allows non-bank financial companies a competitive advantage (via lesser capital backing), banks will attempt to alter the balance of competitive advantage through regulatory arbitrage

More work is needed on stress testing under Basel 2 and banks can expect further, more detailed efforts from regulators in this area. Already, stress testing appears to be a standard management technique for many banks and most banks that stress test do so at a high frequency (daily or weekly): see Fender and Gibson (Risk, 2001).

Perhaps the most fundamental strategic impact of Basel 2 is that it will enhance the SWM (Shareholder Wealth Maximisation) model as the major strategic and managerial model for banks. The essence of this model is its focus on risk and return and the impact of this tradeoff on bank value; the model also emphasises the need for greater risk sensitivity in risk assessments and pricing. Within this model, better risk management is rewarded.

5.3. THE SPANISH SAVINGS BANKS AND THE NEW REGULATORY FRAMEWORK

Although most of the strategic implications mentioned earlier for retail banks apply also to Spanish savings banks, there are some specific features of the Spanish savings banks that may modify some of these conclusions. These specific features are explored in this section (and summarised in Diagram 1):

There have been some recent regulatory actions regarding risk and capital in the Spanish banking system that should be taken into account when defining the threats and opportunities of the new framework for savings banks. The development of a Default Hedging Statistical Fund (the so-called FECI) by the Bank of Spain are two of the recent developments in the regulatory field that impact on the current solvency risk of Spanish savings banks

The establishment of so-called statistical, pro-cyclical or dynamic provisions: Requiring banks to increase these provisions when the business cycle is positive and reducing them during downturns in order to favor intertemporal risk smoothing and loan supply.

Basel 2 does not appear to change the view of banking as a pro-cyclical business. Basel 2 could even exacerbate cyclical effects. It is this contingency that has led the Bank of Spain to establish the so-called pro-cyclical or dynamic provisions.

The recent lending patterns of the Spanish savings banks are known to reduce these pro-cyclical effects since they have increased credit supply almost linearly over the business cycle.

The lending behavior of savings banks has not resulted in higher defaults. On the contrary, default risk management at savings banks has apparently been more efficient than for commercial banks, a fact that may be largely explained by the intertemporal risk smoothing advantages achieved via a close contractual relationship with their customers.

There are three main types of savings-bank specific effects:

(1) those concerning the aim of Basel 2 and the differences between economic and regulatory capital;

(2) those that refer to specialization, size and lending diversification;

(3) those related to the implementation of the new capital adequacy requirements, including the sectoral project of Spanish savings banks for the global control of risk.

(i) Aim of Basel 2 and Economic and Regulatory Capital Differences

While the objective of Stakeholder Wealth Maximization (STWM) may match more closely the nature of Spanish savings banks, SWM should not be a problem for savings institutions since they have to compete with commercial banks. Nevertheless, the SWM model will be reinforced by Basel 2 and Spanish savings banks may benefit from recent regulatory changes that stress their ownership status as private and non-subsidised.

(ii)Size, specialisation and lending diversification

Specialist banks (like savings banks) focusing on a smaller number of core products may also be able to obtain the risk management benefits of specialisation. Continuous calibration and capital treatment may reduce the potential loss of competitiveness in retail banking. Servicing, relationship banking and dynamic lending will also be valued positively.

(iii) Final implementation of Basel 2 on Spanish savings banks: the sectoral project for the global control of risk

The Spanish Confederation of Savings Banks (CECA) has led an ambitious initiative to undertake a sectoral project for the global control of risk. Since this project is oriented to the whole savings bank sector, it has to deal with various problems, like the rigidities of employing a single model for all institutions.

However, the project is targetted to provide savings banks with adequate and centralised human and technological resources in order to implement their own model with a high standard of quality.

The model for each line of business incorporates risk measurement, control and management operating with three different working groups:

information management;

organization and procedures;

quantitative tools.

5.4. COMPARATIVE DESCRIPTIVE STATISTICS

The credit risk of Spanish depository institutions does not seem to be a concern in the short-run.

The ratios doubtful assets/total exposures and doubtful loans of other resident sectors/total exposures of resident sectors have decreased in recent years and are lower than 1% (Table 1).

Statistical provisions have increased over time as a percentage of total provisions (Table 1).

TABLE 1.

Source: Bank of Spain (Memory of Bank Supervision 2004)

Savings banks and credit co-operatives have enjoyed higher margins compared to commercial banks (Table 2). The margins are in line with the European standards.

However, competitive presures have resulted in a decrease of margins over time during the last years.

TABLE 2.


As shown in Table 3, Spanish banks have progressively changed their financial structure to fulfill the requirements of Basel 2.

Both Tier 1 and Tier 2 capital have increased significantly in recent years.

Banks have increased both the average weight of credit risk exposure and off-balance sheet exposure.

TABLE 3.


Changes in capitalization structure have led to an anticipated fulfillment of Basel 2 requirements (Figure 1a).

Tier 1 capital has largely contributed to a reduction in capital requirements, in a context of a significant increase in risk-weighted assets (rise in overall business and Santanders purchase of Abbey National) (Figure 1b).

However, Tier 1 capital has contributed to the growth rate of capital (Figure 1c).

Reserves have contributed largely to the growth of Tier 1 capital while the contribution of intangible assets has been negative (Figure 1d).

FIGURE 1. SOLVENCY RATIOS OF COMMERCIAL AND SAVINGS BANKS IN SPAIN (1)

Source: Bank of Spain (Financial Stability Report, n.8, 2005, May)

Measurement of credit risk

Types of Loans:

C&I (commercial and industrial) loans: secured and unsecuredSyndicationSpot loans, Loan commitmentsDecline in C&I loans originated by commercial banks and growth in commercial paper market.Downgrades of Ford, General Motors and TycoRE (real state) loans: primarily mortgagesFixed-rate, variable ratesMortgages can be subject to default risk when loan-to-value declines.

*CreditMetrics (sistema patentado)

If next year is a bad year, how much will I lose on my loans and loan portfolio?

VAR = P 1.65 s

Neither P, nor s observed.

Calculated using:

(i)Data on borrowers credit rating; (ii) Rating transition matrix; (iii) Recovery rates on defaulted loans; (iv) Yield spreads.

* Credit Risk+ (sistema patentado)

Developed by Credit Suisse Financial Products.Based on insurance literature:Losses reflect frequency of event and severity of loss.Loan default is random.Loan default probabilities are independent.Appropriate for large portfolios of small loans.Modeled by a Poisson distribution.

Credit risk measurement has evolved dramatically over the last 20 years.The five forces made credit risk measurement become more important than ever before:

A worldwide structural increase in the number of bankruptcies.

A trend towards disintermediation by the highest quality and largest borrowers.

(iii) More competitive margins on loans.

(iv) A declining value of real assets in many markets.

(v) A dramatic growth of off-balance sheet instrument with inherent default risk exposure, including credit risk derivatives.

Responses of academics and practitioners:

Developing new and more sophisticated credit-scoring/early-warning systems

Moved away from only analyzing the credit risk of individual loans and securities towards developing measures of credit concentration risk

Developing new models to price credit risk (e.g. RAROC)

Developing models to measure better the credit risk of off-balance sheet instruments

Credit Risk Management

An FIs ability to evaluate information and control and monitor borrowers allows them to transform financial claims of household savers efficiently into claims issued to corporations, individuals, and governmentsAn FI accepts credit risk in exchange for a fair return sufficient to cover the cost of funding (e.g., covering the cost of borrowing, or issuing deposits)

Credit Scoring

Credit scoring system a mathematical model that uses observed loan applicants characteristics to calculate a score that represents the applicants probability of defaultPerfecting collateralensuring that collateral used to secure a loan is free and clear to the lender should the borrower defaultForeclosuretaking possession of the mortgaged property to satisfy a defaulting borrowers indebtedness Power of saletaking the proceedings of the forced sale of property to satisfy the indebtedness

Credit Scoring

Consumer (individual) and Small-business lendingtechniques for scoring consumer loans very similar to mortgage loan credit analysis but more emphasis placed on personal characteristics such as annual gross income and the TDS scoresmall-business loans more complicated and has required FIs to build more sophisticated scoring models combining computer-based financial analysis of borrower financial statements with behavioral analysis of the owner

Ratio Analysis

Historical audited financial statements and projections of future needsCalculation of financial ratios in financial statement analysisRelative ratios offer information about how a business is changing over timeParticularly informative when they differ either from an industry average or from the applicants own past history

Common Size Analysis and After the Loan

Analyst can divide all income statement amounts by total sales revenue and all balance sheet amounts by total assetsYear to year growth rates give useful ratios for identifying trendsLoan covenants reduce risk to lenderConditions precedentthose conditions specified in the credit agreement or terms sheet for a credit that must be fulfilled before drawings are permitted

Large Commercial and Industrial Lending

Very attractive to FIs because transactions are often large enough make them very profitable even though spreads and fees are small in percentageFIs act as broker, dealer, and adviser in credit managementThe standard methods of analysis used for mid-market corporates applied to large corporate clients but with additional complicationsFinancial ratios such as the debt-equity ratio are usually key factors for corporate debt

The KMV Model

Banks can use the theory of option pricing to assess the credit risk of a corporate borrowerThe probability of default is positively related to:the volatility of the firms stockthe firms leverageA model developed by KMV corporation is being widely used by banks for this purpose

Calculating the Return on a Loan

A number of factors impact the promised return that an FI achieves on any given dollar loanthe interest rate on the loanany fees relating to the loanthe credit risk premium on the loanthe collateral backing the loanother nonprice terms (such as compensating balances and reserve requirements)

Return on Assets (ROA)

1 + k = 1 + f + (L + m)

1 - (b(1 - R))

where

k = the contractually promised gross return on the loan

f = direct fees, such as loan origination fee

L = base lending rate

m = risk premium

b = compensating balances

R = reserve requirement charge

Risk-Adjusted Return on Capital (RAROC)

Rather than evaluating the actual or promised annual cash flow on a loan as a percentage of the amount lent (ROA), the lending officer balances the loans expected income against the loans expected risk RAROC = One-year income on a loan/Loan (asset risk or capital at risk

APPENDIX: Bank regulation and credit risk: an example from Basel II and savings banks

Historically, regulation has limited who can:open or charter new banks and what products and services banks can offer.Imposing barriers to entry and restricting the types of activities banks can engage in clearly enhance safety and soundness, but also hinder competition.

It assumed that the markets for bank products, largely bank loans and deposits, could be protected and that other firms could not encroach upon these markets. Not surprisingly, investment banks, hybrid financial companies, insurance firms, and others found ways to provide the same products as banks across different geographic markets.

However, there is another type of regulation that has concentrated most of the attention in the last three decades, the bank capital regulation.Changes in reserve requirements directly affect the amount of legal required reserves and thus change the amount of money a bank can lend out. The main recent example is BASEL II.

Basel 2 is a step change in the regulation of capital adequacy. It will alter the industry frame of reference for banks in many ways: Regulators are clearly recognizing market realities and seeking a much closer congruence between regulatory and economic capital.

The new proposals are more complex and sophisticated than earlier schemes. They will also have to evolve as market conditions, technology and financial management techniques develop.

The calibration exercises that have resulted from the various Quantitative Impact Studies (QIS) are targeted (initially at least) to deliver broadly the same amount of capital as the current Accord. However, the mix of capital charges will change significantly with the wider range of risk weights and greater risk sensitivity of Basel 2.

Basel 2 will clearly be much more risk-sensitive in assigning capital charges. Mortgage lending and lending to higher quality borrowers will be incentivied under Basel 2.

It is not clear whether the present or new Basel Accord are a binding constraint on banks current credit operations. Jackson et al (2001, Bank of England WP) suggest that banks may employ more conservative capital standards than those imposed under Basel 1 or likely under Basel 2.

Compliance costs are likely to increase. Banks will have to evaluate (as a kind of capital investment decision) whether the costs (including compliance costs) of moving to the more advanced Basel 2 systems are worthwhile.

Banks will increasingly target better risk management as a source of competitive advantage. Increasingly, superior risk management will become a key success factor for those banks who are able to respond successfully to the new environment.

Nevertheless, specialist banks who focus on a smaller number of core products and services should similarly be able to obtain risk management benefits of specialization.

Basel 2 will enhance present securitisation trends in banking. This will help in its turn to emphasise further the strategic importance of investment banking. At the same time, lending bankers will face increasing adverse selection trends as the better credits are able to access directly the capital markets.

This trend will help to re-emphasise the importance of credit skills in lending banks. It will also put pressure on these banks to widen their margins (in order to achieve the higher risk premia needed to cover their more risky lending).

Governance will be an increasingly important issue in the new regime. More disclosure is not enough by itself to secure market discipline (the aim of Pillar 3). A wide collection of new and improved governance structures will be needed. These include:

a freer market in bank corporate control;

good corporate governance in banks;incentive-compatible safety nets;no bail-out policies;and proper accounting standards.

Banks will be required to disclose more information than ever before to the external market. This will involve additional compliance costs. Strategically, it will reinforce any competitive advantage gained by good risk-management banks.

Under Pillar 3 and with likely changes in bank governance arrangements, the prospects of take-overs (and no bail-outs) for individual banks who are inefficient are likely to increase. This new world is a likely further threat to concepts like mutuality and subsidised (or at least protected from competition) regional banking.

Insofar as the new capital regime allows non-bank financial companies a competitive advantage (via lesser capital backing), banks will attempt to alter the balance of competitive advantage through regulatory arbitrage

More work is needed on stress testing under Basel 2 and banks can expect further, more detailed efforts from regulators in this area. Already, stress testing appears to be a standard management technique for many banks and most banks that stress test do so at a high frequency (daily or weekly): see Fender and Gibson (Risk, 2001).

Perhaps the most fundamental strategic impact of Basel 2 is that it will enhance the SWM (Shareholder Wealth Maximisation) model as the major strategic and managerial model for banks. The essence of this model is its focus on risk and return and the impact of this tradeoff on bank value; the model also emphasises the need for greater risk sensitivity in risk assessments and pricing. Within this model, better risk management is rewarded.

Although most of the strategic implications mentioned earlier for retail banks apply also to Spanish savings banks, there are some specific features of the Spanish savings banks that may modify some of these conclusions. These specific features are explored in this section (and summarised in Diagram 1):

There have been some recent regulatory actions regarding risk and capital in the Spanish banking system that should be taken into account when defining the threats and opportunities of the new framework for savings banks. The development of a Default Hedging Statistical Fund (the so-called FECI) by the Bank of Spain are two of the recent developments in the regulatory field that impact on the current solvency risk of Spanish savings banks

The establishment of so-called statistical, pro-cyclical or dynamic provisions: Requiring banks to increase these provisions when the business cycle is positive and reducing them during downturns in order to favor intertemporal risk smoothing and loan supply.

Basel 2 does not appear to change the view of banking as a pro-cyclical business. Basel 2 could even exacerbate cyclical effects. It is this contingency that has led the Bank of Spain to establish the so-called pro-cyclical or dynamic provisions.

The recent lending patterns of the Spanish savings banks are known to reduce these pro-cyclical effects since they have increased credit supply almost linearly over the business cycle.

The lending behavior of savings banks has not resulted in higher defaults. On the contrary, default risk management at savings banks has apparently been more efficient than for commercial banks, a fact that may be largely explained by the intertemporal risk smoothing advantages achieved via a close contractual relationship with their customers.

There are three main types of savings-bank specific effects:

(1) those concerning the aim of Basel 2 and the differences between economic and regulatory capital;

(2) those that refer to specialisation, size and lending diversification;

(3) those related to the implementation of the new capital adequacy requirements, including the sectoral project of Spanish savings banks for the global control of risk.

(i) Aim of Basel 2 and Economic and Regulatory Capital Differences

While the objective of Stakeholder Wealth Maximisation (STWM) may match more closely the nature of Spanish savings banks, SWM should not be a problem for savings institutions since they have to compete with commercial banks. Nevertheless, the SWM model will be reinforced by Basel 2 and Spanish savings banks may benefit from recent regulatory changes that stress their ownership status as private and non-subsidised.

(ii)Size, specialisation and lending diversification

Specialist banks (like savings banks) focusing on a smaller number of core products may also be able to obtain the risk management benefits of specialisation. Continuous calibration and capital treatment may reduce the potential loss of competitiveness in retail banking. Servicing, relationship banking and dynamic lending will also be valued positively.

(iii) Final implementation of Basel 2 on Spanish savings banks: the sectoral project for the global control of risk

The Spanish Confederation of Savings Banks (CECA) has led an ambitious initiative to undertake a sectoral project for the global control of risk. Since this project is oriented to the whole savings bank sector, it has to deal with various problems, like the rigidities of employing a single model for all institutions.

However, the project is targetted to provide savings banks with adequate and centralised human and technological resources in order to implement their own model with a high standard of quality.

The model for each line of business incorporates risk measurement, control and management operating with three different working groups:

information management;

organization and procedures;

quantitative tools.

COMPARATIVE DESCRIPTIVE STATISTICS

The credit risk of Spanish depository institutions does not seem to be a concern in the short-run.

The ratios doubtful assets/total exposures and doubtful loans of other resident sectors/total exposures of resident sectors have decreased in recent years and are lower than 1% (Table 1).

Statistical provisions have increased over time as a percentage of total provisions (Table 1).

TABLE 1.


Savings banks and credit co-operatives have enjoyed higher margins compared to commercial banks (Table 2). The margins are in line with the European standards.

However, competitive presures have resulted in a decrease of margins over time during the last years.

TABLE 2.


As shown in Table 3, Spanish banks have progressively changed their financial structure to fulfill the requirements of Basel 2.

Both Tier 1 and Tier 2 capital have increased significantly in recent years.

Banks have increased both the average weight of credit risk exposure and off-balance sheet exposure.

TABLE 3.


Changes in capitalization structure have led to an anticipated fulfillment of Basel 2 requirements (Figure 1a).

Tier 1 capital has largely contributed to a reduction in capital requirements, in a context of a significant increase in risk-weighted assets (rise in overall business and Santanders purchase of Abbey National) (Figure 1b).

However, Tier 1 capital has contributed to the growth rate of capital (Figure 1c).

Reserves have contributed largely to the growth of Tier 1 capital while the contribution of intangible assets has been negative (Figure 1d).

Other Risks Faced by Financial Intermediaries

Risks Faced by Financial Intermediaries

Liquidity RiskInterest Rate RiskMarket RiskOff-Balance-Sheet RiskForeign Exchange RiskCountry or Sovereign RiskTechnology RiskOperational RiskInsolvency Risk

Market Risk

Incurred in trading of assets and liabilities (and derivatives).Examples: Barings & decline in ruble.DJIA dropped 12.5 percent in two-week period July, 2002.Heavier focus on trading income over traditional activities increases market exposure.Trading activities introduce other perils as was discovered by Allied Irish Banks U.S. subsidiary, AllFirst Bank when a rogue trader successfully masked large trading losses and fraudulent activities involving foreign exchange positions

Off-Balance-Sheet Risk

Striking growth of off-balance-sheet activitiesLetters of creditLoan commitmentsDerivative positionsSpeculative activities using off-balance-sheet items create considerable risk

Technology and Operational Risk

Risk that technology investment fails to produce anticipated cost savings.Risk that technology may break down.CitiBanks ATM network, debit card system and on-line banking out for two daysWells FargoBank of New York: Computer system failed to recognize incoming payment messages sent via Fedwire although outgoing payments succeeded

Technology and Operational Risk

Operational risk not exclusively technologicalEmployee fraud and errorsLosses magnified since they affect reputation and future potentialMerrill Lynch $100 million penalty

Country or Sovereign Risk

Result of exposure to foreign government which may impose restrictions on repayments to foreigners.Often lack usual recourse via court system.Examples: ArgentinaRussiaSouth Korea

Indonesia Malaysia Thailand.

Country or Sovereign Risk

In the event of restrictions, reschedulings, or outright prohibition of repayments, FIs remaining bargaining chip is future supply of loansWeak position if currency collapsing or government failingRole of IMFExtends aid to troubled banksIncreased moral hazard problem if IMF bailout expected

Liquidity Risk

Risk of being forced to borrow, or sell assets in a very short period of time. Low prices result.May generate runs.Runs may turn liquidity problem into solvency problem.Risk of systematic bank panics.Example: 1985, Ohio savings institutions insured by Ohio Deposit Guarantee FundInteraction of credit risk and liability riskRole of FDIC (see Chapter 19)

Insolvency Risk

Risk of insufficient capital to offset sudden decline in value of assets to liabilities.Continental Illinois National Bank and TrustOriginal cause may be excessive interest rate, market, credit, off-balance-sheet, technological, FX, sovereign, and liquidity risks.

Insolvency Risk Management

Net wortha measure of an FIs capital that is equal to the difference between the market value o its assets and the market value of its liabilitiesBook Valuevalue of assets and liabilities based on their historical costsMarket value or mark-to-market value basisbalance sheet values that reflect current rather than historical prices

Central Bank & Interest Rate Risk

Federal Reserve Bank: U.S. central bank Open market operations influence money supply, inflation, and interest ratesOct-1979 to Oct-1982, nonborrowed reserves target regime did not workImplications of reserves target policy:Increases importance of measuring and managing interest rate risk.Effects of interest rate targeting.Lessens interest rate riskGreenspan view: Risk ManagementFocus on Federal Funds RateSimple announcement of Fed Funds increase, decrease, or no change.

Implications

Emphasizes importance of:

Measurement of exposureControl mechanisms for direct market riskand employee created risksHedging mechanisms

Market Risk

Market risk is the uncertainty resulting from changes in market prices .

Affected by other risks such as interest rate risk and FX (foreign exchange) riskIt can be measured over periods as short as one day.Usually measured in terms of dollar exposure amount or as a relative amount against some benchmark.

Market Risk Measurement

Important in terms of:Management informationSetting limitsResource allocation (risk/return tradeoff)Performance evaluationRegulationBIS and Fed regulate market risk via capital requirements leading to potential for overpricing of risksAllowances for use of internal models to calculate capital requirements

Tema 6

ANATOMA DE LAS CRISIS BANCARIAS: LA CRISIS CREDITICIA DE 2007 Y 2008

(MATERIAL DEL PROFESOR)

Asymmetric information and its implications

Banking crises

Definition of a banking crisis.

Recent evidence and why we should care.

Sources of banking crises.

Regulatory responses

Strengthening regulation and supervision.

Reforming the financial safety net (deposit insurance and lender of last resort).

Asymmetric Informationand its Implications

Information is asymmetric when one party to an economic relationship or transaction has less information about it than the other party or parties.

Pervasive role in financial markets.

Lenders often do not know the riskiness of the borrower applying for a loan;

Lenders may not be able to observe whether the borrower will invest in a safe or risky project.

Definition

The very existence of financial institutions can be explained on asymmetric-information grounds.

Reason: financial intermediaries

specialize in gathering and analyzing infor-mation about borrowers and their investment projects.

They thereby attenuate the incidence of information asymmetries.

From this perspective, they act as delegated monitors.

Adverse selection. If the price of insurance against a particular contingency is fixed independently of the characteristics of the behavior of the insured, individuals at greater risk will choose to insure.

Moral hazard. After a contract comes into effect, insured agents have an incentive to change their behavior in ways that adversely affect the interests of the insurer.

General Implications

Free-rider problems. An agent that collects infor-mation about a particular risk may be unable to prevent other agents from using that information (e.g. deposit insurance institution that is unable to price risk accurately).

Rational herding. Agents may choose to disregard their own information and instead react to information on the decisions taken by other agents (information externalities).

Principal-agent and monitoring problems. A principal may be unable to observe perfectly the actions of the agent to whom a certain activity or responsibility is delegated. Examples:

Bank shareholders may not perfectly observe investment decisions taken by managers;

regulators may not be able to determine the exact degree of riskiness of loans made by banks.

Adverse selection ensures that a disproportionate number of bad projects are presented for financing.

Borrowers are induced to choose projects for which the probability of default is higher, because riskier projects are associated with higher expected returns.

May lead to credit rationing; see Stiglitz and Weiss (1981).

Banks may be tempted to engage in overly risky lending activities in the presence of deposit insurance.

Implications for the credit market

Banking Crises

Definition of a Banking Crisis

Problematic, no standard definition:

Example: (Detragiache, Demirguc-Kunt (1998a)).

A distress episode is a crisis when

Ratio of nonperforming loans to total bank loans exceeded 10%.

Cost of the rescue operation (or bailout) was at least 2% of GDP.

Episode involved a large-scale nationalization of banks (and possibly other institutions).

Extensive bank runs took place or emergency measures (deposit freezes, prolonged bank holidays, or generalized deposit guarantees) were enacted by the government.

Problems

Information on nonperforming loans: often not reliable and timely. Evergreening problem.

Cost of rescue operations is often difficult to measure due to the importance of quasi-fiscal costs, contingent liabilities, and restructuring costs.

Liquidity provided at below-market interest rates (quasi-fiscal effect).

Promise to bail out ailing banks provides an implicit subsidy.

Estimating the net costs of banking sector restructuring is difficult; requires assumptions about

amount of liquidity support;

present and future incidence of nonperforming loans and their recovery rate.

Estimates are often calculated on a gross basis; leads to overestimation by excluding (Hawkins and Turner (1999))

future proceeds from reprivatization;

loan recovery;

repayment of the liquidity assistance provided by the government.

Run or event criterion: A crisis can indeed, in some cases, be dated that way.

Problems

Runs are often short lived.

Dramaticevents rarely represent either the beginning, or the end, of the crisis.

In most cases insolvency problems were already present and worsening; event itself is merely the point at which underlying problems are revealed (either to the regulator or the public).

Subprime Mortgage Crisis

Background Introduction

What is Subprime lending? the practice of making loans to borrowers who do not qualify for the best market interest rate because of their deficient credit history or inability to prove they could for the loans they are applying.Subprime loan involves high risks.

--housing market

--a combination of high interest rates, bad credit history and murky financial situations associated with the applicants.

Causes of the Crisis

Many factors created the crisis, but the most immediate causes were a rising interest rate environment which caused people with adjustable rate mortgages (ARM) to see significant increases in their mortgage payments, and declining property values as the national real estate market finally began making corrections (Housing bubble bursts).

Role of Mortgage lenders

--Incomplete lending procedure. For example, Many of the sub-prime loans did not even require that borrowers document the income listed on their loan application with a pay stub. some of the lending probably involved actual fraudulence where people misstated their income and qualifications.

--adjustable-rate mortgages (ARM); interest-only adjustable-rate mortgages

Role of Subprime borrowershomeowners

--With the assumption that housing prices would continue to increase, many subprime borrowers are encouraged to obtain ARM.

--Difficult to refinance due to declining property values.

Role of Regulators

--In response to a concern that lending environment was too easy or say, not properly regulated, the House and Senate are both considering making some new bills to regulate lending practices.

Part III- The countrywide influence and the corresponding reactions

Drastic fluctuation in stock market--investors began to worry about whether the Subprime crisis will turn into a global economic one.Many investment banks, mortgage lenders, real estate investment trusts and hedge funds suffered significant losses as a result of mortgage payment defaults or mortgage asset devaluation.

--New Century Finance; American Home Mortgage

--Merrill Lynch;Citigroup

The recession of housing market and the continually increased oil prices will slow down the step of economic growth rate of the U.S.

Subprime Mortgage Crisis

Sharp rise in home foreclosures in late 2006 Only 9% in 1996, 13% in 1999, 20% in 2006 $1.3 Trillion subprime mortgage as of March 2007The delinquency rate had risen to 21% by 2008

Subprime BorrowersFor poor credit historyLimited income

Subprime LendersGreater risksHigh returns

New Model of Mortgage Lending

Source: BBC News


The Housing DownturnExcess supply of home inventorySales volume of new homes droppedReduced market prices (10.4% 12/06-12/07)Increasing foreclosure rates

BorrowersDifficulties in re-financingBegin to default on loansWalk away from propertiesFraudulent misrepresentations


Financial InstitutionsAttraction from high returnsOffered high-risk loan and incentivesBelieves that will pass on the risk to others

SecuritizationMortgage backed securitiesRisk readily transferred to other investorsFrom 54% in 2001 to 75% in 2006


Government and RegulatorsCommunity Reinvestment Act, encourages the development of the subprime debacleGlass-Steagall Act contributes to the subprime crisis (FDIC back up)

Central banksLess concerned with avoiding asset bubblesReact after bubbles burst to minimize the impactNo determination on monetary policyInstitutions risk more because of Feds rescue

Direct Impacts of the Crisis

Stock Market

08/15/07 Dow Jones had dropped below 13,000 from Julys 14000First 3 weeks of 08, the Dow Jones Industrial Average fell 9%1/18/08 Dow Jones/0.5%, S&P 500/0.6%, and NASDAQ/0.3%01/21/08 (black Monday) the worlds biggest falls since Sept. 11, 2001


Financial Institutions Bankruptcy

New Century Financial (USA) Apr. 2, 2007American Home Mortgage (USA) Aug. 6, 2007Sentinel management Group (USA) Aug. 17, 2007Ameriquest (USA) Aug. 31, 2007NetBank (USA) Sept. 30, 2007Terra Securities (Norway) Nov. 28, 2007American Freedom Mortgage Inc. (USA) Jan. 30, 2007


Financial Institutions Write-Downs

Citigroup (USA) - $24.1 blnMerrill Lynch (USA) - $22.5 blnUBS AG (Switzerland) - $16.7 blnMorgan Stanley (USA) - $10.3Credit Agricole (France) - $4.8 blnHSBC (United Kingdom) - $3.4 blnBank of America (USA) - $5.28 blnCIBC (Canada) 3.2 blnDeutsche Bank (Germany) - $3.1 bln

By 02/19/08 losses or write-downs > U.S. $150 bln

Be expected exceeding $200 - $400 bln

Domestic Impacts of the Crisis

Home OwnersHousing prices down 10.4% in Dec. 07 vs. year-agoSales of new homes dropped by 26.4% in 07 vs. 06By Jan. 2008, the inventory of unsold new homes stood at 9.8 months, the highest level since 1981.Two million families will be evicted from their homes

MinoritiesDisproportionate level of foreclosures in minority 46% Hispanics, 55% blacks got higher cost loans

Domestic Impacts of the Crisis

Economy ConditionRecessionLow GDP growth rateBusiness close out or lose money (banks, builders etc.)Weak financial marketLow consumer spendingLose jobsOther credit marketsCredit card Car loan

Global Impacts of the Crisis

Investors will be very cautious to actLack confidence in stock/bound marketConsumer spending will slowdownLack of cash or unwilling to spendWorld economy may slip into recession U.S. economy condition will affect global economyGDP growth will be lowLose businessesLose jobsEconomy slow down

Global Impacts of the Crisis

Financial market May take long time to recoverUnemployment rate may be highSlow economy increase unemployment rateExports will decrease in China, Korea, Taiwan GDP growth heavily depends on export

Government and Central Banks Actions

08/2007, President Bush announced Hope New Alliance02/13/08, President signed a tax rebates of $168 bln 09/18/07, the Fed dropped rate point10/31/07, point cut by Fed12/11/07, point cut by Fed01/22/08 the Fed slashed the rate by 3/4 points to 3.5%01/30/08 another cut of 1/2 points to 3%Central Banks have pumped billions of dollars to banksCentral Banks of the world have done the same thing

Tema 7

LAS REDES DE SEGURIDAD, LOS SEGUROS DE DEPSITOS Y LOS INCENTIVOS DE LA BANCA INTERNACIONAL

LECTURA DE REFERENCIA: CARB ET AL. 2008. EN PRENSA

Banking Crises: Regulatory Responses

Information disclosure.

Strengthening regulation and supervision.

Reforming the financial safety net (deposit insurance and lender of last resort).

Information disclosure

Transparency (e.g. improvements in standards for data dissemination): viewed as important to crisis prevention.

Can help markets to improve their pricing of risk, prevent the buildup of imbalances, and force policymakers to take timely action to address vulnerabilities.

However: information disclosure is not a cure-all. Information is noisy and can be misinterpreted; perverse effect: bank runs.

Strengthening regulation and supervision

Current consensus: bank supervision needs to be strengthened before financial liberalization.

Objectives: ensure adequate internal controls and procedures, avoid concentrated patterns of credit or market risk exposure...

enforce accounting principles and disclosure requirements...

impose stricter asset classification and provisioning practices that reduce the scope for delay in recognizing bad loans, and encourage banks to make adequate provisions against loan losses.

Also: improve incentives for supervisors. Risks of forbearance (leaving insolvent banks in operation) and regulatory capture: create moral hazard, regulation becomes ineffective.

October 1997: Basle Committee on Banking Supervision released 25 core principles for effective banking supervision that cover

licensing structure,

prudential regulations and requirements,

methods for on-site and off-site banking supervision,

information requirements,

prerogatives of supervisors.

Prudential regulations aimed at containing risks associated with capital flows:

Limits on banks open net foreign currency positions (difference between unhedged foreign-currency assets and liabilities).

Limits on exposure to volatility in equity and real-estate markets

would help to insulate the banking system from bubbles associated with large capital inflows

and help to avoid excessive concentration of credit risk.

Discourage excessive exposures of domestic firms and (indirectly banks) by taxing short-term capital inflows (e.g. Chile).

Impose marginal reserve requirements on deposits (higher as the maturity of deposits shortens); help to

insulate the banking system from exposure to the risks of abrupt reversals in capital flows;

prevent a credit boom driven by a surge in bank deposits (ensures a gradual expansion of banks' loan portfolios).

Attractive goal when capital inflows take mostly the form of short-term bank deposits.

Problems

measures could result in some degree of disintermediation of capital inflows;

they do not discriminate between weak (or undercapitalized) banks and strong banks, whose behavior is less risky and credit assessment capacity is strong.

Documents

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