Financial Markets,Financial Markets,Institutions & Instruments; Institutions & Instruments;

Derivatives Derivatives and Bank and Bank RegulationRegulation

ECO 473 – Money & Banking – Dr. D. ECO 473 – Money & Banking – Dr. D. FosterFoster

I. Financial I. Financial Markets,Markets,

Institutions Institutions &&

Instruments Instruments

Match savers and investors◦ Savers want to wealth◦ Investors want to create wealth

Spread/share risk.

Successful strategy - diversification◦ Savers seek out mutual funds◦ Savers seek out financial intermediaries◦ Investors seek OPM

◦ banks◦ credit unions◦ S&Ls◦ thrifts◦ savings banks

pension funds Insurance companies mutual funds mortgage brokers investment bankers finance companies

Why - Intermediation Who . . .

Financial Markets - Why & WhoFinancial Markets - Why & Who

A financial intermediary Banks raise funds by accepting deposits.

Banks use the funds to make loans.

Banks as a solution to “asymmetric info.”

◦ How does this occur for “direct” finance?

S&L, Thrifts, Credit Unions also.

Not “Investment” banks.

When one party to a transaction knows more than the other party.

Adverse selectionAdverse selection - parties to a transaction have different information sets.◦Borrowers as inherently risky.

Moral hazardMoral hazard - after the transaction, behavioral changes adversely affect one party.◦How is the $ used?◦Bernard Madoff.

Involved on Wall Street since 1960.

Prominent philanthropist.

Client losses = $65 bill. “Ponzi” scheme:

◦Began in 1991.

◦“Model” unreplicated.

◦Targeted charities.

◦Client suicides.

New - Primary MarketsNew - Primary Markets◦ stocks (IPO), bonds, mortgages, other.

Used - Secondary MarketsUsed - Secondary Markets◦ exchange of ownership.

Where: NYSE,NASDAQ,OTC . . .

Financial Markets - New & UsedFinancial Markets - New & Used

Short - Money MarketsShort - Money Markets◦ A financial instrument that

matures w/in one year.

◦ Used to facilitate liquidity demands.

Need funds soon.

Have excess cash.

3 mo. & 6 mo. T-Bills Commercial paper Bank CDs

Fed’l funds Repurchase agreements Bankers’ acceptances Euro$ funds

Financial Markets - Short & Financial Markets - Short & LongLong

Money Market Instruments Outstanding, April Money Market Instruments Outstanding, April 20052005

Long - Capital MarketsLong - Capital Markets◦ Maturities of more than one year.

◦ Used for capital purchases (investment).

◦ Less liquid & more risk than MM.

Corporate stock Corporate bonds U.S. Treasury bonds

Other U.S. & Munis Mortgages Comm./Con. loans

Financial Markets - Short & Financial Markets - Short & LongLong

1930s Regs/diversification option?

2008 - collapse of MBSs.

Bear Stearns - couldn’t roll over debt.

Lehman Brothers - $639 bill. in assets.

Merrill Lynch - sold to BoA

Goldman Sachs & Morgan Stanley- converted to commercial banks.

Federal Financing Bank Banks for Cooperatives Federal Intermediate

Credit Banks Federal Land Banks

Federal National Mortgage Association (FNMA, or “Fannie Mae”)

General National Mortgage Association

(GNMA, or “Ginnie Mae”)

Federal Home Loan Banks (FHLBs)

Federal Home Loan Mortgage Corporation

(FHLMC, or “Freddie Mac”)

Sell diversification to individual savers. Government regulations limit risks. 8,000 mutual funds in the United States.

Raise money from wealthy people/institutions Largely unregulated

◦ Use leverage which magnifies gains/losses.

◦ Trade in derivative instruments.

Mutual Mutual FundsFunds

Hedge Hedge FundsFunds

A brokerbroker buys and sells securities for others◦ May be “full service” or “discount.”

A dealerdealer buys and sells for itself, making a market in these securities.

UnderwritesUnderwrites and advises companies on mergers and acquisitions.

Investment banks buy and sell securities and derivatives.

Brokers and Brokers and DealersDealers

Investment Investment BanksBanks

Google structured IPO as a “DutchDutch” auction.

Google saved on investment bank services.

Presumption is Google earned more $$.

◦ Had touted a price of $135 earlier.

◦ Ended up with a price of $85$85.

◦ Earned $1.67 billion on sale.

Conclusion: Investment underwriters are not biased!Investment underwriters are not biased!

Case - Google IPOCase - Google IPO

After After IPO, IPO,

traded traded at $106at $106

After After IPO, IPO,

traded traded at $106at $106

Aug. 20, trading Aug. 20, trading at about $460at about $460

8/2012 trading 8/2012 trading at about $542at about $542

Case - Google IPOCase - Google IPO

At peak, traded at At peak, traded at almost $715almost $715

At peak, traded at At peak, traded at almost $715almost $715

II. II. DerivativeDerivativeFinancial Financial

InstrumentsInstruments

Forward contracts Future contracts Options Swaps

Interest rates Currency Stock Commodities WeatherWeather

Derivative Financial Derivative Financial InstrumentsInstruments

Derivatives in . . Derivatives in . . ..

Hedging/Insuring against adverse changes …Hedging/Insuring against adverse changes …

You have $10 million in U.S. Treasuries with a nominal yield of 5% which matures 5 years from now. But, you only want to hold these bonds for 3 more years.

Risk – If interest rates rise, the price will fall.Risk – If interest rates rise, the price will fall.

Hedge – execute a forward contract, Hedge – execute a forward contract, promising to sell bonds in 3 years at a price promising to sell bonds in 3 years at a price yielding 5.1%.yielding 5.1%.

““Purpose” of a Purpose” of a DerivativeDerivative

Hedging/Insuring against adverse changes …Hedging/Insuring against adverse changes …

You need to buy €5 million in 6 months,the current exchange rate is $1.33/ €. But, you think the dollar will depreciate by then.

Risk – If the dollar falls, it costs more to buy €.Risk – If the dollar falls, it costs more to buy €.

Hedge – go “long” and agree to buy €, Hedge – go “long” and agree to buy €, through a futures contract, at $1.36 each.through a futures contract, at $1.36 each.

““Purpose” of a Purpose” of a DerivativeDerivative

Forward:Forward:◦ Variable in content.◦ Settled at maturity date.◦ Matching participants.

Future:Future:◦ Standardized amounts and terms.◦ Ongoing settlement cash flows.◦ Active, liquid market.◦ Default can’t hurt other party.

Forward vs. Future Forward vs. Future ContractContract

Hedging/Insuring against adverse changes …Hedging/Insuring against adverse changes …

You need to buy €5 million in 6 months,the current exchange rate is $1.33/ €.But, you think the dollar will depreciate by then.

Risk – If the dollar falls, it costs more to buy €.Risk – If the dollar falls, it costs more to buy €.

Alternative Hedge – buy a call option to Alternative Hedge – buy a call option to purchase Euros at $1.40 each; exercise only if purchase Euros at $1.40 each; exercise only if the rate moves higher than that.the rate moves higher than that.

““Purpose” of a Purpose” of a DerivativeDerivative

Hedging/Insuring against adverse changes …Hedging/Insuring against adverse changes …

You pay a variable return on $25 million worth of outstanding bonds.

Risk – If interest rates rise, so do your costs.Risk – If interest rates rise, so do your costs.

Hedge – execute an interest rate swap, to gain Hedge – execute an interest rate swap, to gain a fixed payment schedule, and reducing your a fixed payment schedule, and reducing your exposure to interest rate changes.exposure to interest rate changes.

““Purpose” of a Purpose” of a DerivativeDerivative

Bank agrees to buy bonds in one year at a price that earns 5% . . . thinking rates will fall.

Buy/sell currency futures if you expect rates to move contrary to market.

Buy options to leverage your investment.

Actions raise market liquidity for non-Actions raise market liquidity for non-speculators!!speculators!!

Derivatives as Derivatives as speculativespeculative

1992 – Nick Leeson becomes a trading manager at Baring Securities in Singapore.

Charged with executing client option orders and arbitraging price differences between SIMEX and Osaka exchanges.

Took “speculative positions” in futures linked to Nikkei 225 and Japanese gov’t. bonds.

Hid losses in an unused error account:$400 m. – 1994 and $1.4 b. – 1995

Fled Singapore; arrested in Germany.

Case: Barings Bank - 1762 to Case: Barings Bank - 1762 to 19951995

Hedging against adverse changes..Hedging against adverse changes..

You own $25 million worth of outstanding bonds.

Risk – If the firm goes bankrupt . . .Risk – If the firm goes bankrupt . . .

Hedge – buy a credit default swap, Hedge – buy a credit default swap, and make a fixed payment and make a fixed payment (insurance). If firm goes bust, (insurance). If firm goes bust, the seller owes you for the bond the seller owes you for the bond (difference).(difference).

The Credit Swap The Credit Swap DerivativeDerivative

First one in 1995 (J.P. Morgan)First one in 1995 (J.P. Morgan)

• By 2008, $45 trillion in value.By 2008, $45 trillion in value.• As speculation – buy & sell to manage risk.As speculation – buy & sell to manage risk.• You don’t need to own bond!You don’t need to own bond!• Done OTC.Done OTC.• Party-to-party transaction.Party-to-party transaction.• Settlement/liquidity issues.Settlement/liquidity issues.• Build a virtual bond portfolio.Build a virtual bond portfolio.• Insider trading issue . . .Insider trading issue . . .

The Credit Swap The Credit Swap DerivativeDerivative

Maintaining depository institution liquidity.

Assuring bank solvency bylimiting failures.

Promoting an efficient financial system.

Protecting consumers.

The Banking Act of 1933 (Glass-Steagall Act):◦ Created the Federal Deposit Insurance

Corporation (FDIC).

◦ Placed interest rate ceilings on checking deposits of commercial banks.

◦ Separated commercial and investment banking.

◦ Branching restrictions.

Disintermediation in the 1970s.

1980 - Depository Institutions 1980 - Depository Institutions Deregulation and Monetary Control Act Deregulation and Monetary Control Act (DIDMCA):(DIDMCA):

◦ Six-year phaseout of interest rate ceilings. ◦ Permitted NOW accounts.◦ Increased FDIC coverage to $100,000.

The Garn–St. Germain Act of 1982:The Garn–St. Germain Act of 1982:◦ Authorized money market deposit accounts.

◦ Increase the DIDMCA limit on consumer loans and commercial paper.

◦ Authorized savings institutions to make commercial real estate loans.

◦ Gave these institutions the power to purchase “unsecured loans,” including low-rated, “junk” bonds.

◦ Gave the FDIC power to permit troubled financial institutions to merge with healthier partners.

1989 - Financial Institutions Reform, 1989 - Financial Institutions Reform, Recovery & Enforcement Act (FIRREA)Recovery & Enforcement Act (FIRREA):

◦ Authorized taxpayer funds to cover cost of liquidating failed thrifts.--Insurance wasn’t enough!

◦ Abolished current thrift regulatory structure.--Created Office of Thrift Supervision.--Created the Resolution Trust Corp. to liquidate thrifts.

◦ Moved thrift insurance (FSLIC) into FDIC.

◦ Required insurance fund = 1.25% of insured deposits.

The moral-hazard problem of deposit The moral-hazard problem of deposit insuranceinsurance:◦ S&L crisis.

Too-big-to-fail policyToo-big-to-fail policy:◦ Continental IllinoisContinental Illinois.

The FDIC Improvement Act Of 1991The FDIC Improvement Act Of 1991-- Allowed for earlier intervention by the FDIC.-- Let FDIC set/change premiums to boost fund.-- Mandated risk-based premium structure.

ResolutionDepository Assets Failure Cost Institution ($ Billions) Date ($ Billions)

First Republic Bank (Dallas) $33.5 July 1988 $3.9

MCorp (Dallas) 15.7 February 1989 2.8

Continental Illinois (Chicago) 33.6 May 1984 1.1

Texas American (Fort Worth) 4.8 July 1989 1.1

First City Bancorp (Houston) 4.8 April 1988 1.1

Bank of New England (Boston) 21.8 January 1991 0.9

Goldome FSB (Buffalo) 8.7 May 1988 0.8

New York Bank for Savings (NYC) 3.4 March 1982 0.8

1st National Bank of Keystone (WV) 1.1 September 1999 0.8

Crossland Savings Bank (Brooklyn) 7.3 January 1992 0.7

Superior Bank (Illinois) 2.3 July 2001 0.6

Capital requirementsCapital requirements:◦ Minimum equity capital standards.

Risk-based capital requirementsRisk-based capital requirements:

◦ Risk factors that distinguish different depository institutions. [Degree of capitalization.]

Risk-adjusted assetsRisk-adjusted assets:◦ A weighted average of bank assets to account

for risk differences across types of assets. [Type of capitalization.]

Act removes Glass-Steagall restrictionsand permits:

◦ Securities firms and insurance companies to own commercial banks.

◦ Banks to underwrite insurance andsecurities, including shares of stock.

Off-balance-sheet banking:◦ Loan commitment; credit default swaps.

Asset valuation:◦ Historical cost vs. market value

Derivatives:◦ Replacement cost exposure.◦ Credit/market/operating risks.

New wave of regulation:◦ SOX; Dodd-Frank

Financial Markets,Financial Markets,Institutions & Instruments; Institutions & Instruments;

Derivatives Derivatives and Bank and Bank RegulationRegulation

ECO 473 – Money & Banking – Dr. D. ECO 473 – Money & Banking – Dr. D. FosterFoster