J. K. Dietrich - FBE 525 - Fall, 2006 Portfolios, Risks, and Regulation of Financial Firms Week 10 – October 26, 2006

J. K. Dietrich - FBE 525 - Fall, 2006

Portfolios, Risks, and Regulation of Financial Firms

Week 10 – October 26, 2006


Correlation and Efficiency

Most financial institutions have levered portfolios– Deposits and loans– Insurance reserves and investments

Correlation between cash flows can be positive, zero, or negative– Short-term vs. long-term rate movements– Deposit costs and lending activity– Policy loans and cancellations, benefits


Efficient Portfolios

< 1

= 1

Asset 1 Risk

Asset 2

Asset 2 Risk

Ass

et 2

Ret

urn

Ass

et 1

Ret

urn

0

Asset 1= Liability


Portfolio Constraints

Asset regulation/activity regulation Capital requirements Restrictions on portfolio can

– Lower returns

– Raise risks

– Increase desired leverage


Constrained Portfolios

r

0

Unconstrained and Efficient

Constrained (inefficient)


Equilibrium and Risks

Equilibrium – Short-run and long-run– Outcomes in equilibrium– Risk and equilibrium

Shocks to equilibrium– Real shocks– Monetary shocks

Strategy, equilibrium, and risk


Macroeconomic Risks

Current events in financial markets– Stock market– Interest rates– Causes?– Short-run and long-run implications?

Policy and demographics– California industries– Prospects and opportunities?


Types of Portfolio Risk

Holding-period yield risk– Capital gains risk– Reinvestment risk– Market risk

Credit risk– Non-payment of principal– Delayed or reduced payments– Effect of change is creditworthiness on value

Operating and liquidity risks


U.S. Stock Market 1970-2004

Source: Haver Data Base

0

200

400

600

800

1000

1200

1400

1600

60 65 70 75 80 85 90 95 00

SP500

S&P 500 Index


Monetary Shocks and Rates

-40

-30

-20

-10

0

10

20

30

40

50

1960 1965 1970 1975 1980 1985 1990 1995 2000

CHGINBASE FFED

Change in Moneary Base and Fed Funds Rate


Components of Discount Rates

-3

-2

-1

0

1

2

3

4

5

1960 1965 1970 1975 1980 1985 1990 1995 2000

RISKPREMIUM TERMPREMIUM

Term and Risk Premia in BAA Bond Rate


Risky Rate: Components

0

4

8

12

16

20

1960 1965 1970 1975 1980 1985 1990 1995 2000

FBAAFAAA

FTBS3FCM10

Baa Aaa 10YrTreasury 3-Month Treasury Yields


Microeconomic Risks

Specific market changes in area of specialization

Technology changes Approach management of microeconomic

risks– Diversification– Barriers to micro-economic risk management:

geography, authorities


Rationales for Regulation of Financial Services

Economic activity– Monetary policy (money creation)– Credit allocation (‘disadvantaged’ sectors)– Government financing

Competition (equal opportunity and fairness)

Asymmetry between providers and users Uninsurable (system-wide) risks

– Safety and promoting public confidence


Types of Financial Firm Regulation

Chartering, branching, and registration Ownership, mergers, acquisitions Pricing and product review Activity and asset restrictions Capital requirements Disclosure and examination


Recent Legislative History - U.S.

Pre 1980 DIDAMCA (1980) Garn-St Germain Act (1982) Competitive Equality Banking Act (1987) FIRREA (1989) FDICIA (1991) Riegle-Neal Banking Act (1994) Gramm-Leach-Bliley Act (1999)


Deposit-Taking Regulation

Reserve requirements Investments

» Prohibited investments (e.g. corporate equity}

» Prohibited activities (e.g. real estate development)

» Restrictions on allowable investments (25% equity to one borrower)

Examination and reporting Capital requirements Closure rules (since FDICIA)


Capital Adequacy

Capital bufferBuffer = Assets - Liabilities =>Liabilities = Assets - Capital =>

Liabilities = Assets - Capital Assessing capital adequacy over time (U.S.)

– ABC– Leverage– Risk-based capital


Overview of Capital Regulation

Risk adjusted assets– Basel Agreements – we have case (Nov. 20)– Banks, thrifts, and insurance companies– Risk weights, on- and off- balance sheet– Tier 1 and Tier 2

Value-at-risk (VAR) capital requirements– Internal models, trading assets 10% or $1

billion, after January, 1998– 3 x 10-day 99th percentile risk and benchmarks


Changes and Risks

“Legal Developments” in Federal Reserve Bulletin– Issues raised– Strategic importance

Rationale for regulation– “Systemic risk”– Important discussion


Holding Company Regulation

Bank holding companies– Bank Holding Company Act of 1956– 1970 amendments– FIRREA changes

Non-bank holding companies– Thrifts– Insurance companies– Securities firms


Holding Companies andGlass-Steagall Act (to 1999)

Securities FirmInsurance Company

Non-Bank HoldingCompany

Bank HoldingCompany

Commercial Bank

Securities Subsidiary(Section 20)

SEC, ExchangesSROs

State InsuranceAgencies

Federal ReserveBoard

OCC, FDIC, orFRB


Securities Markets Regulation

Issuers and investors– Registration and disclosure

Investor behavior– Insider trading– Market manipulation– Speculation and margin requirements

Investors and brokers– NASD and exchanges


Securities Firm Regulation Registration Reporting (FOCUS) Capital requirements

– Haircuts Self-regulatory organizations

– NYSE– NASD– Futures Merchants Association

Government


Legal Liabilities

Securities Regulation

MutualFunds

Exchanges and SROs

Brokers,Dealers, IBs

Investor Issuer

Investor

Investor

Issuer

Issuer

Disclosure and Reporting

Man

ipu

lati

on, I

nsi

der

Tra

din

g

SEC ReviewLegal Liabilities


Insurance Regulation

United States vs. Rest of the World– States and McCarran-Ferguson Act– National Association of Insurance

Commissioners (NAIC)– Ministries of Finance, etc., elsewhere

Domestic, foreign, alien insurance companies in United States

EEC and 1992 China, Korea, etc.


Finale: Gramm-Leach- Bliley Act

Established Financial holding companies– Insurance– Securities activities– Maintained separate of banking and commerce in

general Federal Reserve in umbrella regulator, but

regulation relies mainly on function regulators, state insurance commissioners, SEC, CFTC,


Banks with Glass-Steagall

Finance CompanyCommercial Bank

Bank HoldingCompany

Discount Broker

Securities Subsidiary(Section 20)


Financial Holding Company

Investment BankCommercial Bank

Financial HoldingCompany

Insurance Company

Thrift InstitutionAsset Management

Company


Taxation and Financial Services

Taxation of primary sectors– Housing– Corporate tax treatment– Inside build-up– Retirement products

Taxation of financial service firms– Deposit-taking firms– Insurance firms


Taxation and charters

Banks and thrifts– pre 1986– Currently– “Grandfathering” of municipals

Credit unions Mutual and stock insurance companies

– participation Investment companies


Taxation and Financial Products

IRA accounts in the 1980’s Roth accounts in the 1990’s Education savings: 529 and ESAs Leasing and the investment tax credit Limited partnerships Taxation and transaction processing Tax treatment of major banks in the 1980’s

– Political implications


Next Week (November 2)

Read Chapter 19 Begin thinking about Individual Project 3 Coordinate with team members on

integration of individual work into final presentation

Documents

J. K. Dietrich - FBE 525 - Fall, 2006 Portfolios, Risks, and Regulation of Financial Firms Week 10 – October 26, 2006