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1
Financial Institutions, Risk Management, and Regulation
Dr. Gary Brester
MSU Department of Agricultural Economics and Economics
AGBE 445
Spring Semester
2
OUTLINE
1. Banking Functions
2. Banking History
3. Banking Regulations
4. Stress Tests
5. Agricultural and Small Banks
6. International Competitiveness
3
OUTLINE
1. Banking Functions
2. Banking History
3. Banking Regulations
4. Stress Tests
5. Agricultural and Small Banks
6. International Competitiveness
4
Disclaimer
1. Banking and bank regulations
are complex
2. These regulations are evolving
3. Simplified somewhat for
illustration purposes
5
Banking Functions1. Banks are payment agents
a. Facilitate payments through
checking accounts
b. Other electronic funds transfers
2. Banks are intermediaries
a. Facilitate transfer of money
between savers and
borrowers
6
OUTLINE
1. Banking Functions
2. Banking History
3. Banking Regulations
4. Stress Tests
5. Agricultural and Small Banks
6. International Competitiveness
7
Banking History
1. A banking crisis has occurred
approximately every 20 years
2. These crises disrupt financial flows
3. Implications can be minor or severe
a. Can have little impacts
on individuals
b. Or large impacts
8
Safety and Soundness Regulation
1. Adequate liquidity to absorb shocks
2. Capital adequacy to cover all obligations
in the case of bank failure
3. Enforced by government agencies
a. Office of the Comptroller of the
U.S. Treasury
b. Securities and Exchange Commission
4. Bank concentration
9
U.S. Bank Concentration
BanksAssets
($ Trillion)
Total Commercial Bank 13.9
JP Morgan 2.44
Bank of America 2.12
Citigroup 1.98
Wells Fargo 1.44
Top 4 Banks 7.98 (57%)
Top 20 Banks 10.6 (76%)
Total FDIC Banks = 6,900
10
U.S. Bank Failures
YearNumber of
Failures
2000-2007 (total) 26
2008 25
2009 140
2010 157
2011 90
2012 43
2013 35
No failures in Montana since 2000
11
OUTLINE
1. Banking Functions
2. Banking History
3. Banking Regulations
4. Stress Tests
5. Agricultural and Small Banks
6. International Competitiveness
12
Regulatory Milestones
1. Basel (I, II, III)
a. Since 1983
b. International agreements
c. Guide to future domestic regulation
2. Sarbane-Oxley (2002)
3. Dodd-Frank (2010)
13
Basel History
1. Basel agreements have evolved
since 1983
2. Capital adequacy for default risk
a. Been set at 8%
b. Equity must be greater than 8%
of some measure of assets
c. Modified to include Off balance sheet assets Customizable to banks
14
Basel History
3. Considers capital for
a. Market risk
b. Liquidity risk
c. Operations risk
4. Considers the quality of capital
5. Leverage ratio established > 3%
15
OUTLINE
1. Banking Functions
2. Banking History
3. Banking Regulations
4. Stress Tests
5. Agricultural and Small Banks
6. International Competitiveness
16
Capital Sufficiency
1. Loan default
2. Market changes (Mark to Market)
3. Operations failure
4. Measure of capital adequacy
a. Risky capital ratio
Equity / Risky Asset Value
Must be greater than 8%
17
Simplified Bank Balance SheetRisk Risky
Assets Million $ Weight Value Cash 3 0 0 Corp Securities 5 20% 1 Loans Operating 50 100% 50 House Mortgages 40 35% 14 Buildings 2 100% 2Total 100 67
Liabilities Demand Deposits 52 Bonds 40 Loss Reserve 0Total Liabilities 92
Equity 8
Sold Loans (Service) 35 10% 3.5Total Risky Assets 70.5
Risk Capital Ratio 0.113
Off Balance Sheet
18
Basel Standardized Risk Weights
Claims on Sovereigns
AAA to AA 0%
A+ to A- 20%
Less than BBB+ 50% to 150%
Claims on Corporation Including Banks
AAA to AA 20%
A+ to A- 50%
Less than BBB+ 100% to 150%
Retail Products 75%
Residential Property 35%
Commercial Real Estate 100%
Other Assets 100%
19
Basel Standardized Risk Weights1. All non-real estate agricultural loans
a. Set at 100%
2. Agricultural real estate loans
a. Generally set at 100%
b. But, sometimes reduces to rates
closer to home mortgages
3. Must have a risk capital ratio > 8%
4. Leverage ratio (2015)
a. LR = Tier 1 Capital/Total
Exposure
b. > 3%
20
Basel Standardized Risk Weights
5. Tier 1 Capital
a. Common stock
b. Retained earnings
c. Preferred non-accumulating stock
d. No conflicts of interest
6. Total Exposure
a. All risky assets (weights > 0)
b. No risk weighting
21
Simplified Total Exposure
1. Total exposure = 97 million
2. Tier 1 Capital = 8 million
3. Leverage ratio = 8/97 = 8.2%
4. Assume that one-half of the equity did
not qualify as Tier 1 capital
a. LR = 4/97 = 4%
22
Effects of Declining Loan Quality
1. Suppose that $3.5 million of a bank’s
housing loans could go into default
2. Must put $3.5 million into the Loss
Reserve category
23
Loan Defaults Balance SheetRisk Risky
Assets Million $ Weight Value Cash 3 0 0 Corp Securities 5 20% 1 Loans Operating 50 100% 50 House Mortgages 40 35% 14 Buildings 2 100% 2Total 100 67
Liabilities Demand Deposits 52 Bonds 40 Loss Reserve 3.5Total Liabilities 95.5
Equity 4.5
Sold Loans (Service) 35 10% 3.5Total Risky Assets 70.5
Risk Capital Ratio 0.064
Off Balance Sheet
24
Loan Defaults Balance SheetRisk Risky
Assets Million $ Weight Value Cash 43 0 0 Corp Securities 5 20% 1 Loans Operating 50 100% 50 House Mortgages 0 35% 0 Buildings 2 100% 2Total 100 53
Liabilities Demand Deposits 52 Bonds 40 Loss Reserve 3.5Total Liabilities 95.5
Equity 4.5
Sold Loans (Service) 35 10% 3.5Total Risky Assets 56.5
Risk Capital Ratio 0.080
Off Balance Sheet
25
Agriculture and Risk Weights
1. Agriculture loan defaults are low
2. Agriculture returns correlations
a. Low with respect to other
sectors
b. High within agriculture
3. IRB models usually decrease risk
weights for agricultural loans if
a. A bank is not heavily
concentrated in agriculture
26
Internal Risk Based Models1. Alternative to standardized risk
weights
2. IRB is used to customize risk weights
for individual banks
3. This can substantially lower
risk weights
a. Sometimes by as much as 12%
4. Risk weights decline as
a. Probability of defaults decline
b. Default correlations are reduced
27
Comparing Two BanksCapital Ratio Target 10%
ROA 4%
Interest Paid Rate 3.5%
Bank
Item A B
Capital 10 10
Risky Capital 100 100
Risk Weight 25% 60%
Total Assets 400 166.67
Return on Assets over Operations 16 6.67
Interest Paid 13.65 5.48
Net Return 2.35 1.18
ROE 23.5% 11.8%
28
Mark to Market1. Suppose that home interest rates
increase from 3% to 4%
2. Even if home mortgage rates have
been fixed at 3%
a. The value of the bank’s home
mortgages declines
3. Assume an average maturity of
12 years
a. The value of mortgages
declines from 40 million to 37.71
million
29
Mark to Market Balance SheetRisk Risky
Assets Million $ Weight Value Cash 3 0 0 Corp Securities 5 20% 1 Loans Operating 50 100% 50 House Mortgages 37.71 35% 13.1985 Buildings 2 100% 2Total 97.71 66.1985
Liabilities Demand Deposits 52 Bonds 40 Loss Reserve 0Total Liabilities 92
Equity 5.71
Sold Loans (Service) 35 10% 3.5Total Risky Assets 69.7
Risk Capital Ratio 8.2%
Off Balance Sheet
30
Mark to Market on Loans
1. Usually the interest rates on loans
and bonds move together
a. But not always
2. If rates on bonds decline
a. Bond value increases
b. Equity declines
31
Mark to Market Risk Mitigation
1. Sell loans into the secondary market
2. Use complex risk instruments
a. Match variable and fixed
interest rates on bonds and loans
b. Match maturities on bonds
and loans
3. Use credit swaps and other derivatives
32
Future Regulations
1. Consider diversification strategies of
loan portfolios
2. Make adjustments for bank size
3. More IRB customization using
mathematically complex models
a. Stress testing
b. Value at risk
c. Migration models
d. Interest rate spread models
33
OUTLINE
1. Banking Functions
2. Banking History
3. Banking Regulations
4. Stress Tests
5. Agricultural and Small Banks
6. International Competitiveness
34
Agriculture and Risk Weights
1. Agriculture loan defaults are low
2. Agriculture returns correlations
a. Low with respect to other
sectors
b. High within agriculture
3. IRB models usually decrease risk
weights for agricultural loans if
a. A bank is not heavily
concentrated in agriculture
35
Small Bank Challenges1. Personnel capable of IRB analysis
a. Scarce and expensive
2. Access to secondary markets are
more difficult because of small size
3. Credit swaps are often not
accessible
4. Loan portfolios are usually
concentrated
36
OUTLINE
1. Banking Functions
2. Banking History
3. Banking Regulations
4. Stress Tests
5. Agricultural and Small Banks
6. International Competitiveness
37
International Comparisons
Item U.S.Developing Countries
Risk free interest rate includes inflation (LIBOR or U.S. T-bill based) 2.5% 2.5%
Bank margin 3.3% 4.8%
Inflation or currency risk 0 1.5%
Default risk 0.5% 4.0%
Political and Judicial risk 0 5.0%
Commercial farmer interest rate 6.3% 17.8%
38
Credit Impediments:Developing Countries
1. Property rights
a. Not well-established or defined
b. Not useful for collateral Unable to recover
c. Real estate is often
not merchandisable
2. Lack of stable, uniform, and
enforceable business rules of law
39
QUESTIONS