The Effective Use of Capital Chapter 9 Bank Management 6th edition. Timothy W. Koch and S. Scott MacDonald Bank Management, 6th edition. Timothy W. Koch

The Effective Use of Capital

Chapter 9

Bank ManagementBank Management, 6th edition.6th edition.Timothy W. Koch and S. Scott MacDonaldTimothy W. Koch and S. Scott MacDonaldCopyright © 2006 by South-Western, a division of Thomson Learning

Why Worry About Bank Capital?

Capital requirements reduce the risk of failure by acting as a cushion against losses, providing access to financial markets to meet liquidity needs, and limiting growth

Bank capital-to-asset ratios have fallen from about 20% a hundred years ago to around 8% today

Trends in Bank Capital: 1934 - 2004

-1.0%

4.0%

9.0%

14.0%

19.0%

24.0%

Growth rate in total capital Total capital to total assets

Risk-Based Capital

Historically, the minimum capital requirements for banks were independent of the riskiness of the bank Prior to 1990, banks were required to

maintain: a primary capital-to-asset ratio of at

least 5% to 6%, and a minimum total capital-to-asset ratio

of 6%

Risk-Based Capital

Primary Capital Common stock Perpetual preferred stock Surplus Undivided profits Contingency and other capital reserves Mandatory convertible debt Allowance for loan and lease losses

Risk-Based Capital

Secondary Capital Long-term subordinated debt Limited-life preferred stock

Total Capital Primary Capital + Secondary Capital

Capital requirements were independent of a bank’s asset quality, liquidity risk, interest rate risk, operational risk, and other related risks

The Basel Agreement

In 1986, U.S. bank regulators proposed that U.S. banks be required to maintain capital that reflects the riskiness of bank assets The Basel Agreement grew to include

risk-based capital standards for banks in 12 industrialized nations

Regulations apply to both banks and thrifts and have been in place since the end of 1992

The Basel Agreement

A bank’s minimum capital requirement is linked to its credit risk The greater the credit risk, the greater the

required capital Stockholders' equity is deemed to be the

most valuable type of capital Minimum capital requirement increased to

8% total capital to risk-adjusted assets Capital requirements were approximately

standardized between countries to ‘level the playing field'

The Basel Agreement

Risk-Based Elements of the Plan1. Classify assets into one of four risk

categories2. Classify off-balance sheet commitments

into the appropriate risk categories3. Multiply the dollar amount of assets in each

risk category by the appropriate risk weight This equals risk-weighted assets

4. Multiply risk-weighted assets by the minimum capital percentages, currently 4% for Tier 1 capital and 8% for total capital

Regional National Bank (RNB), Risk-based Capital (Millions Of Dollars): Category 1 & 2

Assets $ 1,000

Risk Weight

Risk Weighted

Assets Category 1: Zero Percent Cash & reserve 104,525 0.00% 0 Trading Account 830 0.00% 0 U.S. Treasury & agency secs. 45,882 0.00% 0 Federal Reserve stock 5,916 0.00% 0 Total category 1 157,153 0 Category 2: 20 percent Due form banks / in process 303,610 20.00% 60,722 Int. bearing Dep./F.F.S. 497,623 20.00% 99,525 Domestic dep. institutions 38,171 20.00% 7,634 Repurchase agreements (U.S. Treas & agency) 329,309 20.00% 65,862 U.S. Agencies (gov. sponsored) 412,100 20.00% 82,420 State & Muni's secured tax auth 87,515 20.00% 17,503 C.M.O. backed by agency secs. 90,020 20.00% 18,004 SBAs (govt. guaranteed portion) 29,266 20.00% 5,853 Other category 2 assets 0 20.00% 0 Total category 2 1,787,614 357,523

Regional National Bank (RNB), Risk-based Capital (Millions Of Dollars): Category 3 & 4

Assets $ 1,000

Risk Weight

Risk Weighted

Assets Category 3: 50 percent C.M.O. backed by mtge loans 10,000 50.00% 5,000 State & Muni's / all other 68,514 50.00% 34,257 Real estate: 1-4 family 324,422 50.00% 162,211 Other category 3 assets 0 50.00% 0 Total category 3 402,936 201,468 Category 4: 100 percent Loans: comm/ag/inst/leases 1,966,276 100.00% 1,966,276 Real estate, all other 388,456 100.00% 388,456 Allowance for loan and lease losses (70,505) 0.00% 0 Other investments 168,519 100.00% 168,519 Premises, eq. other assets 194,400 100.00% 194,400 Other category 4 assets 0 100.00% 0 Total category 4 2,647,146 2,717,651 Total Assets before Off-Balance Sheet 4,994,849 3,276,642

Regional National Bank (RNB), Risk-based Capital (Millions Of Dollars): Off Balance Sheet

Assets $ 1,000

Risk Weight

Risk Weighted

Assets Total Assets before Off-Balance Sheet 4,994,849 3,276,642 Off-Balance Sheet Contingencies 0% collateral category 0 0.00% 0 20% collateral category 0 20.00% 0 50% collateral category 364,920 50.00% 182,460 100% collateral category 290,905 100.00% 290,905 Total Contingencies 655,825 473,365

Total Assets and Contingencies before allowance for loan and lease losses and ATR

5,650,674 3,750,007

Less: Excess allowance for loan and lease losses (2,152)

Total Assets and Contingencies 5,650,674 3,747,855

Capital requirements Actual Capital

Minimum Required Capital

(%)

Required Capital

(Minimum) Tier I @ 4% 199,794 4.00% 149,914 Total capital @ 8% 399,588 8.00% 299,828

General Description Of Assets In Each Of The Four Risk Categories

Asset

Category

Risk

Weight

Effective Total Capital Requirement*

Obligor, Collateral, or Guarantor of the Asset

1 0% 0%

Generally, direct obligations of OCED central government or the U.S. federal government; e.g., currency and coin, government securities, and unconditional government guaranteed claims. Also, balances due or guaranteed by depository institutions.

2 20% 1.6%

Generally, indirect obligations of OCED central government or the U.S. federal government; e.g., most federal agency securities, full faith and credit municipal securities, and domestic depository institutions. Also, assets collateralized by federal government obligations are generally included in this category; e.g., repurchase agreements (when Treasuries serve as collateral) and CMOs backed by government agency securities.

3 50% 4% Generally, loans secured by 1–4 family properties and municipal bonds secured by revenues of a specific project (revenue bonds).

4 100% 8% All other claims on private borrowers; e.g., most bank loans, premises, and other assets.

*Equals 8% of equivalent risk-weighted assets and represents the minimum requirement to be adequately capitalized.

Regional National Bank (RNB), Off-balance Sheet Conversion Worksheet

$ Amount

Credit Conversion

Factor

Credit Equivalent $ Amount

Contingencies 100% conversion factor Direct Credit substitutes 165,905 100.00% 165,905

Acquisition of participations in BA, direct credit substitutes

0 100.00% 0

Assets sold w/ recourse 0 100.00% 0 Futures & forward contracts 50,000 100.00% 50,000 Interest rate swaps 75,000 100.00% 75,000 Other 100% collateral category 0 100.00% 0 Total 100% collateral category 290,905 290,905 Contingencies 50% conversion factor Transaction-related contingencies 0 50.00% 0 Unused commitments > 1 year 364,920 50.00% 182,460 Revolving underwriting facilities (RUFs) 0 50.00% 0 Other 50% collateral category 0 50.00% 0 Total 50% collateral category 364,920 182,460 Contingencies 20% conversion factor Short-term trade-related contingencies 0 20.00% 0 Other 20% collateral category 0 20.00% 0 Total 20% collateral category 0 0 Contingencies 0% conversion factor Loan commitments < 1 year 0 0.00% 0 Other 0% collateral category 0 100.00% 0 Total 0% collateral category 0 0 Total off-balance sheet commitment 655,825 473,365

*BA refers to bankers acceptance.

Summary of Risk Categories and Risk Weights for Risk-based Capital Requirements

Asset Category

Risk Weight

Effective Total Capital Requirement

Obligor, Collateral, or Guarantor of the Asset

1 0% 0%

Generally, direct obligations of the federal government; e.g., currency and coin, government securities, and unconditional government guaranteed claims. Also balances due or guaranteed by depository institutions.

2 20% 1.6%

Generally, indirect obligations of the federal government; e.g.; most federal agency securities, full faith and credit municipal securities, and domestic depository institutions. Also assets collaterlized by federal government obligations are generally included in this category; e.g., repurchase agreements (when Treasuries serve as collateral) and CMOs backed by government agency securities.

3 50% 4% Generally, loans secured by one to four family properties and municipal bonds secured by revenues of a specific project (revenue bonds).

4 100% 8% All other claims on private borrowers.

What Constitutes Bank Capital?

Capital (Net Worth) The cumulative value of assets minus the

cumulative value of liabilities Represents ownership interest in a firm

Total Equity Capital Equals the sum of:

Common stock Surplus Undivided profits and capital reserves Net unrealized holding gains (losses) on

available-for-sale securities Preferred stock

Risk-based capital standards …two measures of qualifying bank capital

Tier 1 (Core) Capital Equals the sum of:

Common equity Non-cumulative perpetual preferred stock Minority interest in consolidated subsidiaries,

less intangible assets such as goodwill Tier 2 (Supplementary) Capital

Equals the sum of: Cumulative perpetual preferred stock Long-term preferred stock Limited amounts of term-subordinated debt Limited amount of the allowance for loan loss

reserves (up to 1.25 percent of risk-weighted assets)

What Constitutes Bank Capital?

Leverage Capital Ratio Equals:

Tier 1 capital divided by total assets net of goodwill and disallowed intangible assets and deferred tax assets

Regulators are concerned that a bank could acquire practically all low-risk assets such that risk-based capital requirements would be virtually zero

To prevent this, regulators have also imposed a 3 percent leverage capital ratio

Risk-based Capital Ratios For Different-sized U.S. Commercial Banks, 1995–2004

Asset Size

Year < $100 Million

$100 Million to $1 Billion

$1 to $10

Billion > $10 Billion

All Commercia

l Banks 2004 3,655 3,530 360 85 7,630 Number of Institutions Reporting 2000 4,842 3,078 313 82 8,315

1995 6,658 2,861 346 75 9,940

2004 11.52 10.00 10.90 9.95 10.10 Equity capital ratio (percent) 2000 11.08 9.6 8.99 8.05 8.49

1995 10.42 9.39 8.57 7.19 8.11

Return on equity (percent) 2004 8.46 12.88 13.48 14.24 13.82 Core capital (leverage) ratio (percent) 2004 11.31 9.47 9.36 7.23 7.83 Tier 1 risk-based capital ratio (percent) 2004 16.83 12.85 12.34 9.11 10.04 Total risk-based capital ratio (percent) 2004 17.93 14.06 13.92 12.07 12.62

SOURCE: FDIC, Quarter Banking Profile, http://www2.fdic.gov/qbp.

FDICIA and Bank Capital Standards

The Federal Deposit Insurance Improvement Act (FDICIA) focused on revising bank capital requirements to: Emphasize the importance of capital Authorize early regulatory intervention in

problem institutions Authorized regulators to measure interest

rate risk at banks and require additional capital when it is deemed excessive.

The Act required a system for prompt regulatory action It divides banks into categories according to

their capital positions and mandates action when capital minimums are not met

Minimum Capital Requirements across Capital Categories

Total Risk-

Based Ratio

Tier 1 Risk- Based Ratio

Tier 1 Leverage

Ratio

Capital Directive / Requirement

Well capitalized 10% & 6% & 5% Not subject to a capital directive to meet a specific level for any capital measure

Adequately capitalized 8% & 4% & 4% Does not meet the definition of well capitalized

Undercapitalized < 8% or < 4% or < 4%

Significantly undercapitalized

< 6% or < 3% or < 3%

Critically undercapitalized

Ratio of tangible equity to total assets is 2%

Provisions for Prompt Corrective Action

Category Mandatory Provisions Discretionary Provisions

Well capitalized None None Adequately capitalized 1. No brokered deposits, except with

FDIC approval None

Undercapitalized

1. Suspend dividends and management fees

2 Require capital restoration plan 3. Restrict asset growth 4. Approval required for acquisitions,

branching, and new activities 5. No brokered deposits

Order recapitalization 2. Restrict interaffiliate transactions 3. Restrict deposit interest rates 4. Restrict certain other activities 5. Any other action that would better

carry out prompt corrective action

Significantly undercapitalized

1. Same as for Category 3 2. Order recapitalization 3. Restrict interaffiliate transaction 4. Restrict deposit interest rates 5. Pay of officers restricted

1. Any Zone 3 discretionary actions 2. Conservatorship or receivership if

fails to submit or implement plan or recapitalize pursuant to order

3. Any other Zone 5 provision, if such action is necessary to carry out prompt corrective action

Critically undercapitalized

1. Same as for Category 4 2. Receiver/conservator within 90

daysd 3. Receiver if still in Category 5 four

quarters after becoming critically undercapitalized

4. Suspend payments on subordinated debtd

5. Restrict certain other activities

Tier 3 Capital Requirements for Market Risk

Many large banks have increased the size and activity of their trading accounts, resulting in greater exposure to market risk Market risk is the risk of loss to the bank

from fluctuations in interest rates, equity prices, foreign exchange rates, commodity prices, and exposure to specific risk associated with debt and equity positions in the bank’s trading portfolio

Market risk exposure is, therefore, a function of the volatility of these rates and prices and the corresponding sensitivity of the bank’s trading assets and liabilities

Tier 3 Capital Requirements for Market Risk

Risk-based capital standards now require all banks with significant market risk to measure their market risk exposure and hold sufficient capital to mitigate this exposure

A bank is subject to the market risk capital guidelines if its consolidated trading activity equals 10% or more of the bank’s total assets or $1 billion or more in total dollar value Banks subject to the market risk capital

guidelines must maintain an overall minimum 8 percent ratio of total qualifying capital to risk-weighted assets and market risk equivalent assets

Capital Requirements for Market Risk Using Internal Models

Value-at-Risk (VAR) An internally generated risk

measurement model to measure a bank’s market risk exposure

It estimates the amount by which the value of a bank’s position in a risk category could decline due to expected losses in the bank’s portfolio because of market movements during a given period, measured with a specified confidence level

What is the Function of Bank Capital?

For regulators, bank capital serves to protect the deposit insurance fund in case of bank failures

Bank capital reduces bank risk by: Providing a cushion for firms to absorb

losses and remain solvent Providing ready access to financial

markets, which provides the bank with liquidity

Constraining growth and limits risk taking

How Much Capital is Adequate?

Regulators prefer more capital Reduces the likelihood of bank failures

and increases bank liquidity Bankers prefer less capital

Lower capital increases ROE, all other things the same

Riskier banks should hold more capital while low-risk banks should be allowed to increase financial leverage

How much is “enough” capital?

A “well capitalized” bank: ≥ 5% Core (leverage) capital ≥ 6% Tier 1 risk-based capital ≥ 10 % total risk-based capital

Clearly, additional capital is needed for higher risk assets and future growth.

Full Year: 2004Source: FDIC

TABLE III-A. Full Year 2004, FDIC-Insured Commercial Banks

All Comm Banks

< $100 Mil

$100 Mil -

$1 Bil

$1 - $10 Bil

> $10 Bil

Trend with Size

Number of institutions reporting 7,630 3,655 3,530 360 85 Capital Ratios

Core capital (leverage) ratio 7.83 11.31 9.47 9.36 7.23 Tier 1 risk-based capital ratio 10.04 16.83 12.85 12.34 9.11 Total risk-based capital ratio 12.62 17.93 14.06 13.92 12.07

Weakness of the Risk-Based Capital Standards

Standards only consider credit risk Ignores interest rate risk and liquidity risk

It ignores: Changes in the market value of assets Unrealized gains (losses) on held-to-maturity

securities The value of the bank’s charter The value of deposit insurance

99% of banks are considered “well capitalized” in 2004-2005 Not a binding constraint for most banks

The Effect of Capital Requirements on Bank Operating Policies

Limiting Asset Growth The change in total bank assets is restricted

by the amount of bank equity

Where TA = Total Assets EQ = Equity Capital ROA = Return on Assets DR = Dividend Payout Ratio EC = New External Capital

DR)(1ROAEQ/TA

ΔEC/TADR)(1ROAΔTA/TA

Maintaining Capital Ratios With Asset Growth: Application

Case 1 Case 2 Case 3 Case 4

Ratio

Intitial Position

Initial 8%Asset

Growth

12% Growth: ROA

12% Growth: ROA

12% Growth: External

CapitalAsset growth rate (percent) 8.00% 12.00% 12.00% 12.00%Asset size (millions of $) 100.00 108.00 112.00 112.00 112.00

ROA (percent)a 0.99% 1.43% 0.99% 0.99%Dividend payout rate (percent) 40.00% 40.00% 13.42% 40.00%Undivided Profits (millions of $) 4.00 4.64 4.96 4.96 4.665Total capital less undivide profits (millions of $) 4.00 4.00 4.00 4.00 4.295Total capital / total assets (percent) 8.00% 8.00% 8.00% 8.00% 8.00%

Maintaining Capital Ratios With Asset Growth: Application

Operating Policies Effect on Capital Requirements

Changing the Capital Mix Internal versus External capital

Change Asset Composition Hold fewer high-risk category assets

Pricing Policies Raise rates on higher-risk loans

Shrinking the Bank Fewer assets requires less capital

Characteristics of External Capital Sources

Subordinated Debt Advantages

Interest payments are tax-deductible No dilution of ownership interest Generates additional profits for shareholders

as long as earnings before interest and taxes exceed interest payments

Disadvantages Does not qualify as Tier 1 capital Interest and principal payments are

mandatory Many issues require sinking funds


Common Stock Advantages

Qualifies as Tier 1 capital It has no fixed maturity and thus

represents a permanent source of funds Dividend payments are discretionary Losses can be charged against equity,

not debt, so common stock better protects the FDIC


Common Stock Disadvantages

Dividends are not tax-deductible, Transactions costs on new issues

exceed comparable costs on debt Shareholders are sensitive to earnings

dilution and possible loss of control in ownership

Often not a viable alternative for smaller banks


Preferred Stock A form of equity in which investors'

claims are senior to those of common stockholders

Dividends are not tax-deductible Corporate investors in preferred stock

pay taxes on only 20 percent of dividends

Most issues take the form of adjustable-rate perpetual stock


Trust Preferred Stock A hybrid form of equity capital at banks It effectively pays dividends that are tax

deductible To issue the security, a bank establishes a

trust company The trust company sells preferred stock to

investors and loans the proceeds of the issue to the bank

Interest on the loan equals dividends paid on preferred stock

The interest on the loan is tax deductible such that the bank deducts dividend payments

Counts as Tier 1 capital


Leasing Arrangements Many banks enter into sale and

leaseback arrangements Example:

The bank sells its headquarters and simultaneously leases it back from the buyer

The bank receives a large amount of cash and still maintains control of the property

The net effect is that the bank takes a fully depreciated asset and turns it into a tax deduction

Capital Planning

Process of Capital Planning Generate pro formal balance sheet and

income statements for the bank Select a dividend payout Analyze the costs and benefits of

alternative sources of external capital

2005 2006 2007 2008 2009

Historical 10% Growth in Assets: $250,000 In DividendsTotal assets $ 80.00 $ 88.00 $ 96.80 $ 106.48 $ 117.13Net interest margin 4.40% 4.40% 4.50% 4.60% 4.70%ROA 0.45% 0.45% 0.60% 0.65% 0.75%Total capital $ 5.60 $ 5.75 $ 6.08 $ 6.52 $ 7.15Capital ratio 7.00% 6.53% 6.28% 6.12% 6.10%

Shrink the Bank, reduce assets by $1 million a year: $250,000 In DividendsTotal assets $ 80.00 $ 79.00 $ 78.00 $ 77.00 $ 76.00Net interest margin 4.40% 4.40% 4.50% 4.60% 4.70%ROA 0.45% 0.45% 0.60% 0.65% 0.75%Total capital $ 5.60 $ 5.71 $ 5.92 $ 6.17 $ 6.49Capital ratio 7.00% 7.22% 7.59% 8.02% 8.54%

Slow Growth, $2 million increase in assets each year: No DividendsTotal assets $ 80.00 $ 82.00 $ 84.00 $ 86.00 $ 88.00Net interest margin 4.40% 4.40% 4.50% 4.60% 4.70%ROA 0.45% 0.45% 0.60% 0.65% 0.75%Total capital $ 5.60 $ 5.97 $ 6.47 $ 7.03 $ 7.69Capital ratio 7.00% 7.28% 7.71% 8.18% 8.74%

Total assets $ 80.00 $ 82.00 $ 84.00 $ 86.00 $ 88.00Net interest margin 4.40% 4.40% 4.50% 4.60% 4.70%ROA 0.45% 0.45% 0.60% 0.65% 0.75%Total capital $ 5.60 $ 5.72 $ 5.97 $ 7.08 $ 7.49Capital ratio 7.00% 6.97% 7.11% 8.23% 8.51%

Slow Growth, $2 million increase in assets each year: $250,000 In Dividends, $800,000 External Capital Injection In 2004

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Federal Deposit Insurance

Federal Deposit Insurance Corporation Established in 1933 Coverage is currently $100,000 per depositor

per institution Original coverage was $2,500

Initial Objective: Prevent liquidity crises caused by large-scale

deposit withdrawals Protect depositors of modes means against a

bank failure. The large number of failures in the late 1980s

and early 1990s put pressure on the FDIC by slowly depleting the reserve fund

FDIC RESERVE RATIOS, FUND BALANCE, AND INSURED DEPOSITS

The Deposit Insurance Funds Act of 1996 (DIFA)

Included both a one-time assessment on SAIF deposits to capitalize the SAIF fund

Mandated the ultimate elimination of the BIF and SAIF funds by merging them into a new Deposit Insurance Fund

Risk-Based Deposit Insurance

FDIC insurance premiums are based on a risk-based deposit insurance system

The deposit insurance fund reserve ratios are maintained at or above the target Designated Reserve Ratio of 1.25% of insured deposits Deposit insurance premiums are

assessed as basis points per $100 of insured deposits

The Current Assessment Rate Schedule For BIF Insured And SAIF-insured Institutions

Over 90% of all BIF-insured institutions pay no assessments

Insurance Premiums Supervisory Subgroups

Capital Group A B C Well capitalized 0 bp 3 bp 17 bp Adequately capitalized 3 bp 10 bp 24 bp Undercapitalized 10 bp 24 bp 27 bp

bp = basis point, which equals 1/100 of one percent. An FDIC assessment of 20 basis points amount to 20 cents per $100 of insured deposits

Subgroup A - Financially sound institutionsSubgroup B - Institutions that demonstrate weaknesses that could

result in significant deterioration of the institutionSubgroup C - Institutions that pose a substantial probability of loss

to the BIF or SAIF

Federal Deposit Insurance

Problems with Deposit Insurance Deposit insurance acts similarly to bank

capital In banking, a large portion of borrowed funds

come from insured depositors who do not look to the bank’s capital position in the event of default

A large number of depositors, therefore, do not require a risk premium to be paid by the bank since their funds are insured

Normal market discipline in which higher risk requires the bank to pay a risk premium does not apply to insured funds

Problems with Deposit Insurance

Too-Big-To-Fail Many large banks are considered to be

“too-big-to-fail” As such, any creditor of a large bank

would receive de facto 100 percent insurance coverage regardless of the size or type of liability


Deposit insurance has historically ignored the riskiness of a bank’s operations, which represents the critical factor that leads to failure Two banks with equal amounts of domestic

deposits paid the same insurance premium, even though one invested heavily in risky loans and had no uninsured deposits while the other owned only U.S. government securities and just 50 percent of its deposits were fully insured.

The creates a moral hazard problem.


Moral hazard problem, whereby bank managers have an incentive to increase risk. For example, suppose that a bank had a large

portfolio of problem assets that was generating little revenue.

Managers could use deposit insurance to access funds via brokered CDs in $100,000 blocks.

They might invest the funds in risky assets knowing that any profits would offset losses on the problem assets. Losses would be absorbed by the insurance fund in the event of default.


Deposit insurance funds were always viewed as providing basic insurance coverage Historically, there has been fundamental problem

with the pricing of deposit insurance Premium levels were not sufficient to cover

potential payouts The FDIC and FSLIC were initially expected to

establish reserves amounting to 5 percent of covered deposits funded by premiums

Actual reserves never exceeded two percent of insured deposits as Congress kept increasing coverage while insurance premiums remained constant

The high rate of failures during the 1980s and the insurance funds demonstrate that premiums were inadequate


Historically, premiums were not assessed against all of a bank’s insured liabilities Insured deposits consisted only of domestic

deposits while foreign deposits were exempt. Too-big-to-fail doctrine toward large banks

means that large banks would have coverage on 100 percent of their deposits but pay for the same coverage as if they only had $100,000 coverage as smaller banks do

This means that regulators were much more willing to fail smaller banks and force uninsured depositors and other creditors to take losses.

Percentage Of Failed Commercial Banks By Uninsured Depositor Treatment, 1986–1996

100

80

UninsuredProtected

UninsuredUnprotected

60

40

20

01986 1987 1988 1989 1990 1991 1992 1993 1994 1995 1996

100

80

UninsuredProtected

UninsuredUnprotected

60

40

20

01986 1987 1988 1989 1990 1991 1992 1993 1994 1995 1996

BASEL II Capital Standards

The Basel Accord’s approach to capital requirements was primarily based on credit risk, it did not address operational or other types of risk Three Pillars of Regulation

Minimum Capital Requirements Supervisory Review Market Discipline


Credit Risk Banks are allowed to choose between

two approaches to calculate minimum capital

External Credit Assessments Rating Agencies

Internal Rating Systems The bank’s own assessment


Operational Risk The risk of loss resulting from

inadequate or failed internal processes, people, systems, for from external events

Example: 9/11/01 Look at occurrences of fraud


Trading Book (Including Market Risk) Management must demonstrate an

ability to value the positions with an emphasis on marking-to-market exposures


Supervisory Review and Market Discipline Banks should have a process for

assessing overall capital adequacy in relation to their risk profile and a strategy for maintaining their capital levels

Supervisors should review and evaluate banks’ internal capital adequacy assessments and strategies


Supervisory Review Banks should have a process for assessing

overall capital adequacy in relation to their risk profile and a strategy for maintaining their capital levels

Supervisors should: Review and evaluate banks’ internal capital

adequacy assessments and strategies Expect banks to operate with capital above

the minimum regulatory ratios Intervene at an early stage to prevent capital

from falling below regulatory minimums


Market Discipline Regulators will encourage market

discipline for banks by forcing disclosure of key information pertaining to risk

Market participants will be provided with information regarding specific risk exposures, risk assessment practices, actual capital, and required capital so that they can assess the adequacy of capital

Managing the Investment Portfolio

Chapter 13


The Investment Portfolio

Most banks concentrate their asset management efforts on loans Managing investment securities is

typically a secondary role, especially at smaller banks

Historically, small banks have purchased securities and held them to maturity


Large banks, in contrast, not only buy securities for their own portfolios, but they also: Manage a securities trading account Manage an underwriting subsidiary

that helps municipalities issue debt in the money and capital markets


Historically, bank regulators have limited the risk associated with banks owning securities by generally: Prohibiting banks from purchasing

common stock (for income purposes) Limiting debt instruments to

investment grade securities Increasingly, banks are pursuing

active strategies in managing investments in the search for higher yields

Dealer Operations and the Securities Trading Account

When banks purchase securities, they must indicate the underlying objective for accounting purposes: Held-to-Maturity Trading Available-for-Sale


Held to Maturity Securities purchased with the intent

and ability to hold to final maturity Carried at historical (amortized) cost

on the balance sheet Unrealized gains and losses have no

impact on the income statement


Trading: Securities purchased with the intent to

sell them in the near term Carried at market value on the balance

sheet with unrealized gains and losses included in income


Available for Sale: Securities that are not classified as

either held-to-maturity securities or trading securities

Carried at market value on the balance sheet with unrealized gains and losses included as a component of stockholders’ equity


Banks perform three basic functions within their trading activities: Offer investment advice and assistance

to customers managing their own portfolios

Maintain an inventory of securities for possible sale to investors

Their willingness to buy and sell securities is called making a market

Traders speculate on short-term interest rate movements by taking positions in various securities


Banks earn profits from their trading activities in several ways: When making a market, they price

securities at an expected positive spread Bid

Price the dealer is willing to pay Ask

Price the dealer is willing to sell

Traders can also earn profits if they correctly anticipate interest rate movements

Objectives of the Investment Portfolio

A bank’s investment portfolio differs markedly from a trading account Objectives of the Investment Portfolio

Safety or preservation of capital Liquidity Yield Credit risk diversification Help in manage interest rate risk

exposure Assist in meeting pledging requirements


Accounting for Investment Securities FASB 115 requires security holdings to

be divided into three categories Held-to-Maturity (HTM) Trading Available-for-Sale

The distinction between investment motives is important because of the accounting treatment of each


Accounting for Investment Securities A change in interest rates can

dramatically affect the market value of a security

The difference between market value and the purchase price equals the unrealized gain or loss on the security; assuming a purchase at par:

Unrealized Gain/Loss =

Market Value – Par Value


Accounting for Investment Securities Assume interest rates increase and bond

prices fall: Held-to-Maturity Securities

There is no impact on either the balance sheet or income statement

Trading Securities The decline in value is reported as a loss on

the income statement Available-for-Sale Securities

The decline in value reduces the value of bank capital


Safety or Preservation of Capital A primary objective of the investment

portfolio is to preserve capital by purchasing securities when there is only a small risk of principal loss.

Regulators encourage this policy by requiring that banks concentrate their holdings in investment grade securities, those rated Baa (BBB) or higher.


Liquidity Commercial banks purchase debt

securities to help meet liquidity requirements

Securities with maturities under one year can be readily sold for cash near par value and are classified as liquid investments

In reality, most securities selling at a premium can also be quickly converted to cash, regardless of maturity, because management is willing to sell them

Investment Portfolio for a Hypothetical Commercial Bank

Liquidity


Yield To be attractive, investment securities

must pay a reasonable return for the risks assumed

The return may come in the form of price appreciation, periodic coupon interest, and interest-on-interest

The return may be fully taxable or exempt from taxes


Diversify Credit Risk The diversification objective is closely

linked to the safety objective and difficulties that banks have with diversifying their loan portfolios

Too often loans are concentrated in one industry that reflects the specific economic conditions of the region

Investment portfolios give banks the opportunity to spread credit risk outside their geographic region and across different industries


Help Manage Interest Rate Exposure Investment securities are very flexible

instruments for managing a bank’s overall interest rate risk exposure

Banks can select terms that meet their specific needs without fear of antagonizing the borrower

They can readily sell the security if their needs change


Pledging Requirements By law, commercial banks must pledge

collateral against certain types of liabilities.

Banks that borrow via repurchase agreements essentially pledge part of their government securities portfolio against this debt

Public deposits Borrowing from the Federal Reserve Borrowing from FHLBs

Composition of the Investment Portfolio

Money market instruments with short maturities and durations include: Treasury bills Large negotiable CDs Bankers acceptances Commercial paper Repurchase agreements Tax anticipation notes.


Capital market instruments with longer maturities and duration include: Long-term U.S. Treasury securities Obligations of U.S. government agencies Obligations of state and local

governments and their political subdivisions labeled municipals

Mortgage-backed securities backed both by government and private guarantees

Corporate bonds Foreign bonds


Characteristics of Taxable Securities

Money Market Investments Highly liquid instruments which mature

within one year that are issued by governments and large corporations

Very low risk as they are issued by well-known borrowers and a active secondary market exists

Banks purchase money market instruments in order to meet liquidity and pledging requirements and earn a reasonable return

Characteristics of Taxable Securities

Capital Market Investments Consists of instruments with original

maturities greater than one year Banks are restricted to “investment

grade” securities, those rated Baa (BBB) or above; i.e., no junk bonds

If banks purchase non-rated securities, they must perform a credit analysis to validate that they are of sufficient quality relative to the promised yield .

Money Market Investments

Repurchase Agreements (Repos) A loan between two parties, with one

typically either a securities dealer or commercial bank

The lender or investor buys securities from the borrower and simultaneously agrees to sell the securities back at a later date at an agreed-upon price plus interest

Essentially are collateralized federal funds transactions


Repurchase Agreements (Repos) The minimum denomination is generally $1

million, with maturities ranging from one day to one year

The rate on one-day repos is referred to as the overnight repo rate and is quoted on an add-on basis assuming a 360-day year

$ Interest = Par Value x Repo Rate x Days/360 Longer-term transactions are referred to as term

repos and the associated rate the term repo rate


Treasury Bills Marketable obligations of the U.S.

Treasury that carry original maturities of one year or less

They exist only in book-entry form, with the investor simply holding a dated receipt

Investors can purchase bills in denominations as small as $1,000, but most transactions involve much larger amounts


Treasury Bills Each week the Treasury auctions

bills with 13-week and 26-week maturities

Investors submit either competitive or noncompetitive bids With a competitive bid, the purchaser

indicates the maturity amount of bills desired and the discount price offered

Non-competitive bidders indicate only how much they want to acquire


Treasury Bills Treasury bills are purchased on a discount

basis, so the investor’s income equals price appreciation

The Treasury bill discount rate is quoted in terms of a 360-day year:

Where DR = Discount Rate FV = Face Value P = Purchase Price N = Number of Days to Maturity

N

360

FV

PFVDR


Treasury Bills Example: A bank purchases $1 million in face value of

26-week (182-day) bills at $990,390. What is the discount rate and effective yield?

The discount rate is:

The true (effective) yield is:

1.90%182

360

$1,000,000

$990,390$1,000,000DR

1.956%1(365/182)

$990,390$990,390$1,000,0001 YieldEffective


Certificates of Deposit Dollar-denominated deposits issued by

U.S. banks in the United States Fixed maturities ranging from 7 days to

several years Pay yields above Treasury bills. Interest is quoted on an add-on basis,

assuming a 360-day year


Eurodollars Dollar-denominated deposits issued by

foreign branches of banks outside the United States

The Eurodollar market is less regulated than the domestic market, so the perceived riskiness is greater.


Commercial Paper Unsecured promissory notes issued by

corporations Proceeds are use to finance short-term working

capital needs The issuers are typically the highest quality

firms Minimum denomination is $10,000 Maturities range from 3 to 270 days Interest rates are fixed and quoted on a

discount basis Small banks purchase large amounts of

commercial paper as investments


Bankers Acceptances A draft drawn on a bank by firms that

typically are importer or exporters of goods

Has a fixed maturity, typically up to nine months

Priced as a discount instrument like T-bills

Capital Market Investments

Treasury Notes and Bonds Notes have a maturity of 1 - 10 years Bonds have a maturity greater than 10

years Most pay semi-annual coupons

Some are zeros or STRIPS Sold via closed auctions Rates are quoted on a coupon-bearing

basis with prices expressed in thirty-seconds of a point, $31.25 per $1,000 face value


Treasury STRIPS Many banks purchase zero-coupon Treasury

securities as part of their interest rate risk management strategies

The U.S. Treasury allows any Treasury with an original maturity of at least 10 years to be “stripped” into its component interest and principal pieces and traded via the Federal Reserve wire transfer system.

Each component interest or principal payment constitutes a separate zero coupon security and can be traded separately from the other payments


Treasury STRIPS Example Consider a 10-year, $1 million par value

Treasury bond that pays 9 percent coupon interest semiannually ($45,000 every six months)

This security can be stripped into 20 separate interest payments of $45,000 each and a single $1 million principal payment, or 21 separate zero coupon securities.


U.S. Government Agency Securities Composed of two groups

Members who are formally part of the federal government

Federal Housing Administration Export-Import Bank Government National Mortgage Association

(Ginnie Mae)


U.S. Government Agency Securities Composed of two groups

Members who are government-sponsored agencies

Federal Home Loan Mortgage Corporation (Freddie Mac)

Federal National Mortgage Association (Fannie Mae) Student Loan Marketing Association (Sallie Mae)

Default risk is low even though these securities are not direct obligations of the Treasury; most investors believe there is a moral obligation.

These issues normally carry a risk premium of about 10 to 100 basis points.


Callable Agency Bonds Securities issued by government-

sponsored enterprises in which the issuer has the option to call the bonds prior to final maturity

Typically, there is a call deferment period during which the bonds cannot be called

The issuer offers a higher promised yield relative to comparable non-callable bonds

The present value of this rate differential essentially represents the call premium


Callable Agency Bonds Banks find these securities attractive

because they initially pay a higher yield than otherwise similar non-callable bonds

The premium reflects call risk If rates fall sufficiently, the issuer will

redeem the bonds early, refinancing at lower rates, and the investor gets the principal back early which must then be invested at lower yields for the same risk profile


Conventional Mortgage-Backed Securities (MBSs) Any security that evidences an

undivided interest in the ownership of mortgage loans

The most common form of MBS is the pass-through security

Even though many MBSs have very low default risk, they exhibit unique interest rate risk due to prepayment risk

As rates fall, individuals will refinance


GNMA Pass-Through Securities Government National Mortgage

Association (Ginnie Mae) Government entity that buys mortgages

for low income housing and guarantees mortgage-backed securities issued by private lenders

Structure of the GNMA Mortgage-Backed Pass-Through Security Issuance Process


FHLMC Federal Home Loan Mortgage Corporation

(Freddie Mac) FNMA securities

Federal National Mortgage Association (Fannie Mae)

Both are: Private corporations Operate with an implicit federal guarantee Buy mortgages financed largely by mortgage-

backed securities


Privately Issued Pass-Through Issued by banks and thrifts, with private

insurance rather than government guarantee

Prepayment Risk on Mortgage-Backed Securities

Borrowers may prepay the outstanding mortgage principal at any point in time for any reason

Prepayments generally occur because of fundamental demographic trends as well as movements in interest rates Prepayments typically increase as

interest rates fall and slow as rates increase

Forecasting prepayments is not an exact science

Prepayment Risk on Mortgage-Backed Securities

Example: Current mortgage rates are 8% and you

buy a MBS paying 8.25% Because rates have fallen, you paid a

premium to earn the higher rate With rates only .25% lower, it is unlikely

individuals will refinance If rates fall 3%, there will be a large

increase in prepayments due to refinancing

If the prepayments are fast enough, you may never recover the premium you paid

Pre

paym

en

t ri

sk o

n m

ort

gag

e-b

acked

secu

riti

es

Do

lla

rs

5Interest Rate (Percent)

A. The Interest Sensitivity of Mortgage Pass-Throughs (Dollar Value of $100,000 Share in a Mortgage Pool)

130,000

115,000

100,000

85,000

70,0006 7 8 9 10 11 12 13

Constant prepayment rate

Varying prepayment rate

Measures the value of the MBS if the prepayment rate remains at 6% regardless of the level of mortgage rates.

The value of the MBS if the pre-payment rate varies from 6%

Pre-payment experience is low on new mortgages, increases through five years then declines.

B. The Effect of Relative Coupon on the Prepayment Rate

-8Relative Coupon Rate (Percent)

Per

cen

t p

er M

on

th

3

-6 -4 -2 0 2 4 6 8

2

1

0

C. The Effect of Mortgage Age on the Prepayment Rate

Mortgage Age (Years)

1.25

1.00

.75

.50

.25

01 255 10 15 20

Perc

en

t p

er

Mo

nth Pre-payment

rates increase sharply when mortgage rates fall

Unconventional Mortgage-Backed Securities

Collateralized Mortgage Obligations (CMOs) Security backed by a pool of mortgages

and structured to fall within an estimated maturity range (tranche) based on the timing of allocated interest and principal payments on the underlying mortgages

Tranche: The principal amount related to a specific

class of stated maturities on a collateralized mortgage obligation. The first class of bonds has the shortest maturities


Collateralized Mortgage Obligations (CMOs) CMOs were introduced to circumvent

some of the prepayment risk associated with the traditional pass-through security

CMOs are essentially bonds An originator combines various

mortgage pools to serve as collateral and creates classes of bonds with different maturities


Collateralized Mortgage Obligations (CMOs) The first class, or tranche, has the

shortest maturity Interest payments are paid to all classes

of bonds but principal payments are paid to the first tranche until they have been paid off

After the first tranche is paid, principal payments are made to the second tranche, etc


Types of CMOs Planned Amortization Class CMO (PAC)

A security that is retired according to a planned amortization schedule, while payments to other classes of securities are slowed or accelerated

Least risky of the CMOs Objective is to ensure that PACs exhibit highly

predictable maturities and cash flows Z-Tranche

Final class of securities in a CMO, exhibiting the longest maturity and greatest price volatility

These securities often accrue interest until all other classes are retired


CMOs’ Advantages over MBS Pass-Throughs Some classes (tranches) exhibit less

prepayment risk; some exhibit greater prepayment risk

Appeal to investors with different maturity preferences by segmenting the securities into maturity classes


Stripped Mortgage-Backed Securities More complicated in terms of structure and

pricing characteristics Example:

Consider a 30 year, 12% fixed-rate mortgage There will be 30 x 12 (360) payments (principal plus

interest Loan amortization means the principal only payments

are smaller in the beginning: P1 < P2 < … < P360

Interest only payments decrease over time: I1 > I2 > … > I360

Asset-Backed Securities

Conceptually, an asset-backed security is comparable to a mortgage-backed security in structure

The securities are effectively “pass-throughs” since principal and interest are secured by the payments on the specific loans pledged as security

Two popular asset-backed securities are: Collateralized automobile receivables

(CARS) CARDS

Securities backed by credit card loans to individuals

Other Investments

Corporate and Foreign Bonds At the end of 2004, banks held $560

billion in corporate and foreign bonds Mutual Funds

Banks have increased their holdings in mutual funds to over $25 billion in 2004

Mutual fund investments must be marked-to-market and can cause volatility on the values reported on the bank’s balance sheet

Characteristics of Municipal Securities

Municipals are exempt from federal income taxes and generally exempt from state or local as well

General obligation Principal and interest payments are backed

by the full faith, credit, and taxing authority of the issuer

Revenue Bonds Backed by revenues generated from the

project the bond proceeds are used to finance

Industrial Development Bonds Expenditures of private corporations

Summary of Terms for a Municipal School Bond

Due Date Amount Coupon Yield7/1/2003 $225,000 7.00% 2.00%7/1/2004 $520,000 7.00% 2.50%7/1/2005 $545,000 7.00% 3.00%7/1/2006 $575,000 7.00% 3.25%7/1/2007 $605,000 7.00% 3.50%7/1/2008 $635,000 7.00% 3.70%7/1/2009 $665,000 7.00% 3.80%7/1/2010 $700,000 4.00% 3.90%7/1/2011 $735,000 4.00% 4.00%7/1/2012 $765,000 4.13% 4.13%7/1/2013 $800,000 4.25% 4.25%7/1/2014 $835,000 4.38% 4.38%7/1/2015 $870,000 4.50% 4.50%7/1/2016 $910,000 4.60% 4.60%7/1/2017 $950,000 4.70% 4.70%7/1/2018 $995,000 4.80% 4.80%7/1/2019 $1,045,000 4.90% 4.90%7/1/2020 $1,095,000 5.00% 5.00%7/1/2021 $1,150,000 5.00% 5.00%7/1/2022 $1,210,000 5.00% 5.00%7/1/2023 $1,270,000 5.00% 5.00%7/1/2024 $1,335,000 5.00% 5.00%7/1/2025 $1,405,000 5.00% 5.20%7/1/2026 $1,480,000 5.00% 5.21%

7/1/2031 $8,650,000 5.13% 5.21%

Sequoia Union High School District $30,000,000

General Obligation Bonds Election of 2001 Dated: May 1, 2002 Due: July 1, 2003 through July 1, 2031 Callable: July 1, 2011 at 102.0% of par, declining to par as of July 1, 2013 Winning Bid: Salomon Smith Barney, at 100.0000, True interest cost (TIC) of 5.0189% Other Managers: Bear, Stearns & Co., Inc., CIBC World Markets Corp.,


Money Market Municipals Municipal notes provide operating

funds for government units Banks buy large amounts of short-term

municipals They often work closely with

municipalities in placing these securities

Capital Market Municipals Includes general obligation bonds and

revenue bonds


Credit Risk in the Municipal Portfolio Until the 1970s, few municipal securities

went into default Deteriorating conditions in many large

cities ultimately resulted in defaults by: New York City (1975), Cleveland (1978),

Washington Public Power & Supply System (WHOOPS) (1983)


Liquidity Risk Municipals exhibit substantially lower liquidity

than Treasury or agency securities The secondary market for municipals is

fundamentally an over-the-counter market Small, non-rated issues trade infrequently and

at relatively large bid-ask dealer spreads Large issues of nationally known municipalities,

state agencies, and states trade more actively at smaller spreads


Liquidity Risk Name recognition is critical, as investors

are more comfortable when they can identify the issuer with a specific location

Insurance also helps by improving the rating and by association with a known property and casualty insurer


Municipals are less volatile in price than Treasury securities This is generally attributed to the peculiar tax

features of municipals The municipal market is segmented

On the supply side, municipalities cannot shift between short- and long-term securities to take advantage of yield differences because of constitutional restrictions on balanced operating budgets

Thus long-term bonds cannot be substituted for short-term municipals to finance operating expenses, and

Capital expenditures are not financed by ST securities


Municipals are less volatile in price than Treasury securities The municipal market is segmented.

On the demand side, banks once dominated the market for short-term municipals

Today, individuals via tax-exempt money market mutual funds dominate the short maturity spectrum

Establishing Investment Policy Guidelines

Each bank’s asset and liability or risk management committee is responsible for establishing investment policy guidelines These guidelines define the parameters

within which investment decisions help meet overall return and risk objectives

Because securities are impersonal loans that are easily bought and sold, they can be used at the margin to help achieve a bank’s liquidity, credit risk, and earnings sensitivity or duration gap targets

Establishing Investment Policy Guidelines

Investment guidelines identify specific goals and constraints regarding: Return Objective Composition of Investments Liquidity Considerations Credit Risk Considerations Interest Rate Risk Considerations Total Return Versus Current Income

Active Investment Strategies

Portfolio managers can buy or sell securities to achieve aggregate risk and return objectives

Investment strategies can subsequently play an integral role in meeting overall asset and liability management goals

Unfortunately, not all banks view their securities portfolio in light of these opportunities


Many smaller banks passively manage their portfolios using simple buy and hold strategies

The purported advantages are that such a policy requires limited investment expertise and virtually no management time; lowers transaction costs; and provides for predictable liquidity


Other banks actively manage their portfolios by: Adjusting maturities Changing the composition of taxable versus

tax-exempt securities Swapping securities to meet risk and return

objectives Advantage is that active portfolio managers

can earn above-average returns by capturing pricing discrepancies in the marketplace

Disadvantages are: that managers must consistently out predict

the market for the strategies to be successful, and

high transactions costs

The Maturity or Duration Choice for Long-Term Securities

The optimal maturity or duration is possibly the most difficult choice facing portfolio managers

It is very difficult to outperform the market when forecasting interest rates

Some managers justify passive buy and hold strategies because of a lack of time and expertise

Other managers actively trade securities in an attempt to earn above average returns

Passive Maturity Strategies

Laddered (or Staggered) maturity strategy Management initially specifies a

maximum acceptable maturity and securities are evenly spaced throughout maturity

Securities are held until maturity to earn the fixed returns

Passive Maturity Strategies

Barbell Maturity Strategy Differentiates investments between

those purchased for liquidity and those for income

Short-term securities are held for liquidity

Long-term securities for income Also labeled the long and short

strategy

Active Maturity Strategies

Active portfolio management involves taking risks to improve total returns by: Adjusting maturities Swapping securities Periodically liquidating discount

instruments To be successful, the bank must avoid

the trap of aggressively buying fixed-income securities at relatively low rates when loan demand is low and deposits are high

Active Maturity Strategies

Riding the Yield Curve This strategy works best when the yield curve

is upward-sloping and rates are stable. Three basic steps:

Identify the appropriate investment horizon Buy a par value security with a maturity longer

than the investment horizon and where the coupon yield is higher in relationship to the overall yield curve

Sell the security at the end of the holding period when time remains before maturity

Riding the Yield Curve Example

Initial conditions and assumptions: •5-year investment horizon

•yield curve is upward-sloping,

•5-year securities yielding 7.6 % and

•10-year securities yielding 8 %.

•Annual coupon interest is reinvested at 7%.

Expected Total Return Calculation

0.0752

1100,000

5,70538,000100,000i

1/5

5yr

0.0810

1100,000

6,00540,000101,615y

1/5

10yr

Interest Rates and the Business Cycle

Expansion Increasing Consumer Spending Inventory Accumulation Rising Loan Demand Federal Reserve Begins to Slow Money

Growth Peak

Monetary Restraint High Loan Demand Little Liquidity

Interest Rates and the Business Cycle

Contraction Falling Consumer Spending Inventory Contraction Falling Loan Demand Federal Reserve Accelerates Money

Growth Trough

Monetary Policy Eases Limited Loan Demand Excess Liquidity

Passive Strategies Over the Business Cycle

One popular passive investment strategy follows from the traditional belief that a bank’s securities portfolio should consist of primary reserves and secondary reserves

This view suggests that banks hold short-term, highly marketable securities primarily to meet unanticipated loan demand and deposit withdrawals

Once these primary liquidity reserves are established, banks invest any residual funds in long-term securities that are less liquid but offer higher yields


A problem arises because banks normally have excess liquidity during contractionary periods when loan demand is declining and the Fed starts to pump reserves into the banking system

Interest rates are thus relatively low.


Banks employing this strategy add to their secondary reserve by buying long-term securities near the low point in the interest rate cycle Long-term rates are typically above

short-term rates, but all rates are relatively low

With a buy and hold orientation, these banks lock themselves into securities that depreciate in value as interest rates move higher

Active Strategies Over the Business Cycle

Many portfolio managers attempt to time major movements in the level of interest rates relative to the business cycle and adjust security maturities accordingly

Some try to time interest rate peaks by following a counter-cyclical investment strategy defined by changes in loan demand and the yield curve’s shape

Active Strategies Over the Business Cycle

The strategy entails both expanding the investment portfolio and lengthening maturities at the top of they business cycle, when both interest rates and loan demand are high Note that the yield curve generally inverts

when rates are at their peak prior to a recession

Alternatively, at the bottom of the business cycle when both interest rates and loan demand are low, a bank contracts the portfolio and shorten maturities

The Impact of Interest Rates on the Value of Securities with Embedded Options

Issues for Securities with Embedded Options Callable agency securities or mortgage-

backed securities have embedded options To value a security with an embedded

option, three questions must be addressed Is the investor the buyer or seller of the

option? How and by what amount is the buyer being

compensated for selling the option, or how much must it pay to buy the option?

When will the option be exercised and what is the likelihood of exercise?

Price-Yield Relationship for Securities with Embedded Options

7% 9.5%Yield onMortgages

B. High-Coupon, Interest-Only Mortgage-Backed Security

Pri

ce

of

IO

P*

5.78%

3-Year, $100 Par Value FHLB Bond, Callable afterOne Year, Priced at $99.97

Yield

A. Callable Agency Bond

Pri

ce

100

$99.97

The Roles of Duration and Convexity in Analyzing Bond Price Volatility

Recall that the duration for an option-free security is a weighted average of the time until the expected cash flows from a security will be received

i)(1i

PP

- Duration

Pi)(1

iDuration - P

Tangent line representing the slope at 10%

$ Price

10,524.21

10,507.52

10,000.00

8% 10%Interest Rate %

Price-yield curve


Yield % Price Price - $10,000 Duration 8 10,524.21 524.21 5.349 9 10,257.89 257.89 5.339

10 10,000.00 0.00 5.329 11 9,750.00 (249.78) 5.320 12 9,508.27 (491.73) 5.310

Actual price increase is greater when interest rates fall for option free bonds.


From the previous slide, we can see: The difference between the actual

price-yield curve and the straight line representing duration at the point of tangency equals the error in applying duration to estimate the change in bond price at each new yield

For both rate increases and rate decreases, the estimated price based on duration will be below the actual price


From the previous slide, we can see: Actual price increases are greater and

price declines less than that suggested by duration when interest rates fall or rise, respectively, for option-free bonds

For small changes in yield the error is small

For large changes in yield the error is large


Convexity As yields increase, duration for option

free bonds decreases, once again reducing the rate at which price declines

This characteristic is called positive convexity

The underlying bond becomes more price sensitive when yields decline and less price sensitive when yields increase

Impact of Prepayments on Duration and Yield for Bonds with Options

Embedded options affect the estimated duration and convexity of securities

For example, prepayments will affect the duration of mortgage-backed securities Market participants price mortgage-backed

securities by following a 3-step procedure: Estimate the duration based on an assumed

interest rate environment and prepayment speed

Identify a zero-coupon Treasury security with the same (approximate) duration.

The MBS is priced at a mark-up over the Treasury

Impact of Prepayments on Duration and Yield for Bonds with Options

The MBS yield is set equal to the yield on the same duration Treasury plus a spread The spread can range from 50 to 300

basis points depending on market conditions

The MBS yields reflect the zero-coupon Treasury yield curve plus a premium

Total Return Analysis

An investor’s actual realized return should reflect the coupon interest, reinvestment income, and value of the security at maturity or sale at the end of the holding period

When a security carries embedded options, these component cash flows will vary in different interest rate environments


If rates fall and borrowers prepay faster than originally expected: Coupon interest will fall Reinvestment income will fall The price at sale (end of the holding

period) may rise or fall depending on the speed of prepayments


When rates rise Borrowers prepay slower Coupon income increases Reinvestment income increases The price at sale may rise or fall

Tota

l R

etu

rn A

naly

sis

for

a C

allab

le F

HLB

B

on

d

Tota

l R

etu

rn A

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sis

for

a C

allab

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HLB

B

on

d

Option-Adjusted Spread

The standard calculation of yield to maturity is inappropriate with prepayment risk

Option-adjusted spread (OAS) accounts for factors that potentially affect the likelihood and frequency of call and prepayments

Static spread is the yield premium, in percent, that (when added to Treasury zero coupon spot rates along the yield curve) equates the present value of the estimated cash flows for the security with options equal to the prevailing price of the matched-maturity Treasury

Comparative Yields on Taxable versus Tax-Exempt Securities

Interest on most municipal securities is exempt from federal income taxes and, depending on state law, from state income taxes Some states exempt all municipal

interest Most states selectively exempt interest

from municipals issued in-state but tax interest on out-of-state issues

Other states either tax all municipal interest or do not impose an income tax


Capital gains on municipals are taxed as ordinary income under the federal income tax code This makes discount municipals less

attractive than par municipals because a portion of the return, the price appreciation, is fully taxable

When making investment decisions, portfolio managers compare expected risk-adjusted after-tax returns from alternative investments


After-Tax and Tax-Equivalent Yields Once the investor has determined the

appropriate maturity and risk security, the investment decision involves selecting the security with the highest after-tax yield


After-Tax and Tax-Equivalent Yields Tax-exempt and taxable securities can

be compared as:

t)(1RR tm

whereRm = pretax yield on a municipal securityRt = pretax yield on a taxable securityt = investor’s marginal federal income tax rate


After-Tax and Tax-Equivalent Yields Example

Let:Rm = 5.75%Rt = 7.50%

Marginal Tax Rate = 34% The investor would choose the municipal

because it pays a higher after tax return:

Rm = 5.75% after taxesRt = 7.50% (1 - 0.34)

= 4.95% after taxes


Marginal Tax Rates Implied in the Taxable - Tax-Exempt Spread If taxable securities and tax-exempt

securities are the same for all other reasons then:

t* = 1 - (Rm / Rt) where

Rm = pretax yield on a municipal security

Rt = pretax yield on a taxable security


Marginal Tax Rates Implied in the Taxable - Tax-Exempt Spread t* represents the marginal tax rate at

which an investor would be indifferent between a taxable and a tax-exempt security equal for all other reasons

Higher marginal tax rates or high tax individuals (companies) will prefer tax-exempt securities


Example Let:

Rm = 5.75%Rt = 7.50%

Marginal Tax Rate = 34%

An investor would be indifferent between these two investment alternatives if her marginal tax rate were 23.33%


Municipals and State & Local Taxes The analysis is complicated somewhat

when state and local taxes apply to municipal securities:

)]t(t[1R)t(tR mtmm

Comparison of After-Tax Returns on Taxable and Tax-Exempt Securities for a Bank as Investor

After-Tax Interest Earned Recognizing Partial Deductibility of Interest Expense

After-Tax Interest Earned on Taxable versus Exempt Securities

Taxable MunicipalPar Value 10,000$ 10,000$ Coupon Rate 10.00% 8.00%Annual Coupon interest 1,000$ 800$ Federal income taxes (34%) 340$ $0After-tax income 660$ 800$

Par Value 10,000$ 10,000$ Coupon Value 0$ 0$ Annual coupon interest 1,000$ 800$ Federal income taxes (34%) 340$ -$ Polled interest expense (7.5%) 750$ 750$ Lost interest deduction (20%) -$ 150$ Increased tax liability (34%) -$ 51$ Effective after-tax interest income 660$ 749$

The Impact of the Tax Reform Act of 1986 (TRA 1986)

The TRA of 1986 created two classes of municipals Qualified Nonqualified Municipals

After 1986, banks could no longer deduct interest expenses associated with municipal investments, except for qualified municipal issues


Qualified versus Non-Qualified Municipals Qualified Municipals

Banks can still deduct 80 percent of the interest expense associated with the purchase of certain small issue public-purpose bonds (bank qualified)

Nonqualified Municipals All municipals that do not meet the

qualified criteria


Qualified versus Non-Qualified Municipals Municipals issued before August 7,

1986, retain their tax exemption; i.e., can still deduct 80 percent of their associated financing costs (grandfathered in)

The Impact of the Tax Reform Act of 1986 (TRA 1986) Example:

Implied tax on a bank’s purchase of nonqualified municipal securities (100% lost deduction)

Assume t =34% 20% not deductible 7.5% pooled interest cost Rmuni = 7%

5.45%0.3188)(18.0Ratmuni

31.88%00.08

(0.075)(1.00)(0.34)tmuni

Strategies Underlying Security Swaps

Active portfolio strategies also enable banks to sell securities prior to maturity whenever economic conditions dictate that returns can be earned without a significant increase in risk

When a bank sells a security at a loss prior to maturity, because interest rates have increased, the loss is a deductible expense At least a portion of the capital loss is

reduced by the tax-deductibility of the loss


In general, banks can effectively improve their portfolios by: Upgrading bond credit quality by

shifting into high-grade instruments when quality yield spreads are low

Lengthening maturities when yields are expected to level off or decline

Obtaining greater call protection when management expects rates to fall


In general, banks can effectively improve their portfolios by: Improving diversification when

management expects economic conditions to deteriorate

Generally increasing current yields by taking advantage of the tax savings

Shifting into taxable securities from municipals when management expects losses

GLOBAL BANKING ACTIVITIES

Chapter 21


Global banking business One clear trend in the evolution of financial

institutions and markets is the expansion of activities across national boundaries.

Technology has made it possible to conduct business around the world with relative ease and minimal cost.

Producers recognize that export markets are as important as domestic markets, and that the range of competitors includes both domestic and foreign operations.

Global banking activities…involve both traditional commercial banking and investment banking operations.

U.S. commercial banks now accept deposits, make loans, provide letters of credit, trade bonds and foreign exchange, and underwrite debt and equity securities in dollars and other currencies.

With the globalization of financial markets, all firms compete directly with other major commercial and investment banks throughout the world.

Foreign banks offer the same products and services denominated in their domestic currencies and in U.S. dollars.

Still, it was not always this way.

U.S. banks, although a dominant player in some world markets, have not been considered “large” by international standards

Restrictive branching laws, Restrictions on the types of activities U.S.

banks could engage in, and Other regulatory factors generally meant

that

U.S. banks were greater in number, but smaller in size.

U.S. banks, although a dominant player in some world markets, have not been considered “large” by international standards.

Rank Company Name 12/31/1996 1 Bank of Tokyo-Mitsubishi Ltd., Tokyo, Japan $648,161.00 2 Deutsche Bank AG, Frankfurt, Germany 575,072.00 3 Credit Agricole Mutual, Paris, France (2) 479,963.00 4 Credit Suisse Group, Zurich, Switzerland (1) 463,751.40 5 Dai-Ichi Kangyo Bank Ltd., Tokyo, Japan 434,115.00 6 Fuji Bank Ltd., Tokyo, Japan 432,992.00 7 Sanwa Bank Ltd., Osaka, Japan 427,689.00 8 Sumitomo Bank Ltd., Osaka, Japan 426,103.00 9 Sakura Bank Ltd., Tokyo, Japan 423,017.00

10 HSBC Holdings, Plc., London, United Kingdom 404,979.00 17 Chase Manhattan Corp., New York, United States 333,777.00 26 Citicorp, New York, United States (b) 278,941.00

Billions of dollars Source: The AmericanBanker: http://www.americanbanker.com.

By the end of the 20th century, many factors had changed in the U.S. system. The Riegle-Neal Interstate Banking and Branching Efficiency Act of

1994 effectively eliminated interstate branching restrictions in the U.S. such that: by early 1994, there were 10 U.S. banks with 30 interstate branches. by June 2001, there were 288 U.S. banks with 19,298 interstate

branches. U.S. banks were hampered competing internationally by the Glass-

Steagall Act, which effectively separated commercial banking from investment banking. As such, U.S. commercial banks essentially provided two

products: loans and FDIC-insured deposits. In 1999, the Gramm-Leach-Bliley allowed U.S. banks to fully compete

with the largest global diversified financial companies by offering the same broad range of products. The Gramm-Leach-Bliley Act repealed restrictions on banks

affiliating with securities firms and modified portions of the Bank Holding Company Act to allow affiliations between banks and insurance underwriters.

By the end of 2000, the largest banking company in the world was Citigroup at just under one-trillion dollars and three of the largest ten banking companies in the world were U.S. banks.

The merger between Citicorp and Travelers created Citigroup, the first diversified financial services company in the U.S. The merger, however, was not completely permissible at

the time it was approved under provisions of the Glass-Steagall Act. Gramm-Leach-Bliley Act, made this merger permissible

and thereby allowed Citigroup to legally be the world’s largest banking company.

Citigroup formed a financial holding company under the provisions of the Gramm-Leach-Bliley Act and became one of the first integrated financial services companies engaged in investment services, asset management, life insurance and property casualty insurance, and consumer lending.

Operating companies include Salomon Smith Barney, Salomon Smith Barney Asset Management, Travelers Life & Annuity, Primerica Financial Services, Travelers Property Casualty Corp., and Commercial Credit.

Today, the product offerings of Citigroup are similar to that of Deutsche Bank in Germany Prior to the merger between Citibank and Travelers,

however, Citibank’s product line was more limited. Outside the U.S., Citibank was able to offer a

diversified set of products using an Edge Act corporation. Edge Act corporations are domestic subsidiaries of

banking organizations chartered by the Federal Reserve.

All “Edges” are located in the United States and may be established by U.S. or foreign banks and bank holding companies, but are limited to activities involving foreign customers.

They can establish overseas branches and international banking facilities (IBFs) and own foreign subsidiaries.

Foreign banks operating through their American banking offices have also aggressively pursued U.S. business.

50.0%

55.0%

60.0%

65.0%

70.0%

75.0%

80.0%

85.0%

90.0%

95.0%

100.0%

1973

1975

1977

1979

1981

1983

1985

1987

1989

1991

1993

1995

1997

1999

2001

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45.0%

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Pe

rcen

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f to

tal f

ore

ign

ow

ned

Domestic total assets Domestic total depositsForeign owned total assets Foreign owned total deposits

The growth in market share of U.S. offices of foreign banks in total loans and business loans.

50.0%

55.0%

60.0%

65.0%

70.0%

75.0%

80.0%

85.0%

90.0%

95.0%

100.0%

1973

1975

1977

1979

1981

1983

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1987

1989

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1993

1995

1997

1999

2001

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0.0%

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Domestic total loans Domestic business loansForeign owned total loans Foreign owned business loans

The largest U.S. banks with significant international operations.

$ Mill % TA $ Mill % TACitibank NA, New York NY 452,343 98,899 208,024 46.0% 121,901 157,462 34.8% 277J PMorgan Chase Bk, New York NY537,826 160,102 120,371 22.4% 135,872 39,022 7.3% 612Bank of America NA, Charlotte NC 551,691 334,909 56,634 10.3% 287,364 20,867 3.8% 4,350Fleet NA Bk, Providence RI 187,949 110,148 22,316 11.9% 102,956 19,737 10.5% 1,709Bank of New York, New York NY 78,019 28,786 27,024 34.6% 19,822 16,879 21.6% 362Bank One NA, Chicago IL 161,023 81,020 26,358 16.4% 76,440 4,991 3.1% 804MBNA America Bk NA, Wilmington DE43,066 26,187 1,448 3.4% 18,733 4,123 9.6% 3First Union NB, Charlotte NC 232,785 135,276 12,473 5.4% 118,053 3,479 1.5% 2,143State Street B&TC, Boston MA 65,410 12,137 26,718 40.8% 4,519 1,402 2.1% 1Wachovia Bk NA, Winston-Salem NC71,555 42,684 3,627 5.1% 45,434 807 1.1% 790Keybank NA, Cleveland OH 71,526 40,010 2,721 3.8% 54,047 785 1.1% 980PNC Bk NA, Pittsburgh PA 62,610 44,079 2,307 3.7% 39,072 777 1.2% 735Mellon Bk NA, Pittsburgh PA 27,813 9,947 4,949 17.8% 6,269 548 2.0% 346Bank of Hawaii, Honolulu HI 10,493 5,621 1,369 13.0% 5,312 495 4.7% 78Northern Trust Co, Chicago IL 32,758 10,380 9,424 28.8% 11,331 397 1.2% 1National City Bk, Cleveland OH 39,214 20,464 1,007 2.6% 31,022 154 0.4% 353Wells Fargo Bk NA, San Francisco CA140,675 73,644 5,433 3.9% 93,799 20 0.0% 939Wells Fargo Bk MN NA, Minneapolis MN52,428 26,311 7,459 14.2% 34,277 1 0.0% 169

Domestic Offices

# of US BranchesName

Total Assets

Domestic Offices

Foreign Offices Foreign OfficesNet Loans and leasses:Deposits Held in:

The largest “foreign owned” banks operating in the U.S.

Domestic Offices

Foreign Offices

HSBC Bank USA, Buffalo NY 84,230 37,067 21,153 3,194 HSBC Holdings PLC, LONDON NA 100 440 19Lasalle Bank NA, Chicago IL 54,731 24,963 4,226 0 ABN Amro, AMSTERDAM NA 100 122 2Bankers Trust Co, New York NY 42,678 11,423 10,000 253 Taunus Corporation, NEW YORK NY 100 4 14Standard Federal Bk NA, Troy MI 42,088 19,702 624 0 ABN Amro, AMSTERDAM NA 100 385 2Union Bk of CA NA, San Francisco CA 35,591 26,518 3,305 1,041 Bank of Tokyo-Mitsubishi, TOKYO NA 66 286 6Banco Popular De PR, San Juan PR 20,477 11,459 190 10,306 Popular Inc., SAN JUAN PR 100 2 204Harris T&SB, Chicago IL 19,673 9,498 1,708 151 Bank of Montreal, MONTREAL NA 100 57 2Allfirst Bk, Baltimore MD 17,762 12,758 545 249 Allied Irish Banks Limited, DUBLIN NA 100 270 2RBC Centura Bk, Rocky Mount NC 13,732 7,388 273 0 Royal Bank of Canada, MONTREAL NA 100 241 1Bank of The West, San Francisco CA 13,412 9,212 N/A 0 Bancwest Corporation, HONOLULU HI 44 193 0United CA Bk, San Francisco CA 10,524 8,285 428 0 Sanwa Bank, Limited, OSAKA NA 100 121 1First Hawaiian Bk, Honolulu HI 8,682 5,691 463 364 Bancwest Corporation, HONOLULU HI 44 56 6Firstbank PR, San Juan PR 8,143 4,117 N/A 0 First Bancorp, SAN JUAN PR 100 1 49Banco Santander PR, Hato Rey PR 7,656 4,811 0 0 Banco Santander S .A., SANTANDER NA 80 1 72TD Waterhouse Bk NA, Jersey City NJ 6,069 5,546 N/A 0 TD Waterhouse Holdings, Inc., NEW YORK NY 80 2 0Israel Discount Bk of NY, New York NY 6,021 2,112 2,094 415 Israel Discount Bank Limited, TEL-AVIV NA 100 7 1Westernbank Puerto Rico, Mayaguez PR 5,887 3,214 N/A 0 W Holding Company, Inc., MAYAGUEZ PR 100 1 35Banco Popular North America, New York City NY5,606 4,761 0 0 Popular Inc., SAN JUAN PR 100 98 0Safra NB, New York NY 5,010 2,548 320 875 SNBNY Holdings Limited, MARINA BAY NA 99 2 1Banco Bilbao Vizcaya Argenta, San Juan PR 4,801 2,971 N/A 0 BBVAPR Holding Corporation, SAN JUAN PR 100 1 61Bank of Tokyo Mitsubishi TC, New York NY 4,337 1,491 1,310 46 Bank of Tokyo-Mitsubishi, TOKYO NA 100 1 1Bank Leumi USA, New York NY 4,082 1,496 1,800 169 Bank Leumi Le-Israel B.M., TEL-AVIV NA 99 8 1R-G Premier Bk of PR, San Juan PR 3,963 2,115 N/A 0 R&G Financial Corporation, SAN JUAN PR 100 1 25Doral Bk, San Juan PR 3,486 1,528 N/A 0 Doral Financial Corporation, SAN JUAN PR 100 1 26Laredo NB, Laredo TX 2,349 2,029 N/A 0 Incus Co. Ltd., ROAD TOWN NA 71 24 0

# of Foreign

BranchesTotal

Assets

Deposits Held in: Loans in Frgn

Offices Top Holding CompanyName

% Foreign Owned

# of US Branches

Universal banking model

Universal banking is the conduct of a variety of financial services such as: trading of financial instruments; foreign exchange

activities; underwriting new debt and equity issues; investment management, insurance; as well as extension of credit and deposit gathering

Universal banks have long dominated banking in most of continental Europe. Universal banks engage in everything from insurance to investment banking and retail banking— similar to U.S. banks prior to the enactment of the

Banking Act of 1933 and Glass-Steagall provisions and now post the passage of the Gramm-Leach-Bliley Act of 1999

Three events changed the historical development of banking in the U.S.

1. The first was the stock market crash of 1929 and the following Great Depression. Many people blamed the banks and the universal

banking activities for the problems although there is no strong evidence to link the speculative activities of banks with the crash.

2. The second was the enactment of the Banking Act of 1933 and the Glass-Steagall provision, which separated commercial banking from investment banking activities.

3. The third was the rising importance of the federal government in financial markets. Prior to these events, the U.S. banking system

operated more of less under a universal banking system.

The advantages of universal banking…risk diversification and expanded business opportunities.

A universal bank can spread its costs over a broader base of activities and generate more revenues by offering a bundle of products.

Diversification, in turn, reduces risk. insurance companies, investment banks and

other suppliers of financial services are moving toward building financial conglomerates

The GLB Act repealed Glass-Steagall and allows U.S. banks to operate in the business of commercial banking, investment banking, and insurance. Although there are many restrictions, U.S. banks

are allowed to compete with foreign banks on an equal footing for the first time since the passage of the Glass-Steagall Act,

Disadvantages of universal banking…inherent conflict of interest

A universal bank might use pressure tactics to coerce a corporation into using its underwriting services or buy insurance from its subsidiary by threatening to cut off credit facilities.

It could force a borrower in financial difficulties to issue risky securities in order to pay off loans.

A universal bank could also abuse confidential information supplied by a company issuing securities as well. One area of the new GLB Act that has received

significant attention is that of privacy protection

Formation and development of the European Community (EC) will provide new opportunities for U.S. Banks.

By abolishing trade restrictions, the EC exposes European banks to outside competition.

In order to increase their competitive advantage, many banks are looking into merging with banks from other countries.

Today, most of Europe uses a unified currency, the Euro.

Organizational structures in international markets Head office

International divisions or departments are operated as a part of the head office's organizational structure, with the division managers reporting to senior management (supervisory function).

Representative office International office which does not conduct

normal banking business but simply represents the corporation, with the purpose of promoting the corporation's name and developing business to be funneled to the home office (exploratory function).

Foreign offices Foreign branch

A legal part of the home bank which is subject to the laws and regulations of the host nation

Shell office Does not conduct business with local individuals;

serves as a conduit for Eurodollar activities that originate in the head office

Full-service branch Performs all the activities of domestic banks

Foreign Subsidiary Foreign banks or non-bank corporations acquired by

domestic commercial banks or bank holding companies; distinct from the parent bank and performs the same functions as the domestic banks

Edge act and agreement corporations

Edge Act corporations: Domestic subsidiaries of banks

chartered by the Federal Reserve which may be established by U.S. or foreign banks and are limited to activities involving foreign customers.

Agreement corporations: State-chartered equivalents of Edge Act

Corporations.

International banking facilities

Subparts of banks that are created to conduct international business without the cost and effort of avoiding regulatory requirements through shell units.

Exist as a set of accounting entries on the books of the parent company.

Export trading companies

Companies that are acquired by banks and are organized and operated principally for purposes of exporting goods and services produced in the U.S. by unaffiliated persons.

Agencies of foreign banks

Parts of foreign banks that can offer only a limited range of banking services (cannot accept transactions deposits from U.S. residents or issue CDs) with the primary purpose of financing trade originating from firms in their own country.

International financial markets

International markets have evolved to facilitate funds flow in international exchange of goods and services and to reduce the risk of doing business outside the home country.

The Eurocurrency market

Eurocurrency: A deposit liability in any currency

except that of the country in which the bank is located.

Eurobank: Bank that issues Eurocurrency claims.

Eurodollars Arise when a Eurobank accepting the deposit

receives a dollar claim on the U.S. bank from which the funds were transferred.

Eurobanks will redeposit the Eurodollar proceeds in another bank until the funds are given out as a loan by one of the banks.

The initial Eurodollar deposit is accepted at the base rate called LIBOR (London Interbank Offer Rate).

Each redeposit and the final loan will then be priced at a markup over LIBOR.

The Eurobond market

Bonds issued in the international Euromarket, underwritten by an international banking syndicate, not subject to any one country's securities laws, and denominated in any major national currency.

Floating-rate Note: Issued in denominations as low as $5,000 with

maturities ranging from two to five years, carrying interest rates that vary with LIBOR.

Eurocredits…term loans priced at a premium over LIBOR, with the rate floating every three or six months in most cases, thereby reducing the mismatch between asset and liability maturities

Eurocredits are created to overcome interest rate risk.

International lending International operations generate a considerable

portion of earnings for money center banks Citigroup earns about two-thirds of their earnings

globally.

International lending, however, carries risks not associated with domestic lending Country risk

…default risk associated with loans to borrowers outside the home country

Foreign exchange risk …the current and potential volatility in earnings and stockholders’ equity due to changes in foreign exchange rates.

Short-term foreign trade financing…international trade and international trade financing are considerably more complex than simply dealing with trading partners within the same country

To facilitate trade, someone must enter the transaction and assume the risk that the importer may not pay.

Commercial banks fulfill this role through bankers acceptance financing.

Trading partners must also have the opportunity to convert one currency into another, which creates a demand for foreign exchange services as well.

Bankers acceptance…A time draft that represents a guarantee under which the accepting bank agrees to remit the face value of the draft at maturity. Acceptances are attractive because a bank

substitutes its credit rating for that of the importer.

Bankers Acceptance financing of U.S. Imports…a bankers acceptance is created, discounted, sold, and paid at maturity

Direct international loans…originate from international departments of domestic banks, Edge Act corporations, credit offices of foreign branches and subsidiaries.

Credit extended to less-developed countries (LDCs) has exhibited a poor repayment history and many of the banks have chosen to withdraw from lending to these countries after a large number of default incidents that took place in the 1980s.

Banks prefer to have foreign exposure in the form of equity investments rather than long-term, constantly renegotiated loans to foreign central banks.

Credit analysis of foreign loans

Credit analysis for international loans follow the same procedures adopted frequently for domestic loans: evaluation of the required loan amount, use of proceeds, source and timing of expected

payment, availability of secondary collateral

sources.

Foreign exchange activities

Because different countries use different monetary units, traders must be able to convert one unit into another.

Foreign exchange markets are where these monetary units are traded. Foreign exchange

…currency other than the monetary unit of the home country

Exchange rate…the price of one currency in terms of another currency.

Risks unique to international lending: Foreign exchange risk

…the current and potential risk to earnings and stockholders’ equity arising from changes in foreign exchange rates

Country risk …default risk associated with loans to borrowers outside the home country

Economic risks …quantifiable economic and business risks (mostly examined under regular credit analysis).

Political (sovereign) risks …the likelihood that foreign governments will unilaterally alter their debt service payments, regardless of the formal repayment schedule

Foreign Exchange: …currency other than the monetary unit of the home country

Exchange Rate…price of one currency in terms of another currency.

Spot Market:…market for exchange of currencies for immediate delivery.

Forward Market…market for transactions that represent a commitment to exchange currencies at a specified time in the future at an exchange rate determined at the time the contract is signed.

Foreign exchange risk …current and potential risk to earnings and stockholder’s equity arising from changes in foreign exchange rates

Found when changing exchange rates affect a bank’s cash inflows differently than cash outflows associated with positions denominated in different currencies

Changes in values of foreign currency positions (buying and selling foreign currencies for their own account) due to changing foreign exchange rates is price risk

Example: Foreign exchange risk Commerce Bank’s (CB) home country is Poland

and home currency is the zloty. 1. current (spot) exchange rate is $1 = 150 zlotys. 2. Commerce Bank:

1. $1,000 in loans2. $250 in liabilities denominated in U.S. dollars3. assets are worth 150,000 zlotys4. liabilities are worth 37,500 zlotys at the

prevailing exchange rate.

If the exchange rate moved to $1 = 160 zlotys, 1. assets increase in value by 10,000 zlotys,2. liabilities increase by 2,500 zlotys. 3. the bank’s equity would rise by 7,500 zlotys.

Example (continued): Foreign exchange risk

If the exchange rate moved to $1 = 140 zlotys, 1. assets decrease in value by 10,000 zlotys,

2. liabilities decrease by 2,500 zlotys

3. the bank’s would see stockholders’ equity decrease by 7,500 zlotys

These same exposures exist for off-balance sheet commitments and guarantees when counterparties effect the at risk transactions or activities.

Managing foreign exchange rate risk

A bank’s risk managers analyze aggregate foreign exchange risk by currency.

A bank’s net balance sheet exposure in currency j (NEXPj) is the amount of assets minus the amount of liabilities denominated in currency j: NEXPj = Aj – Lj

whereAj = assets denominated in currency j,Lj = liabilities denominated in currency j.

If NEXPj > 0, the bank is long on currency j and if NEXPj < 0, the bank is short currency j.

Gain/Loss in a position

The bank will lose if: it is long a currency (NEXPj > 0) and the

currency depreciates in value (the currency buys less of another currency).

if it is short a currency (NEXPj < 0) and the currency appreciates in value (the currency buys more of another currency).

The gain/loss in a position with a currency is indicated by: Gain/Loss in a Position With Currency j

= NEXPj x [spot exchange rate at time t – spot exchange rate at time t-1]

Example: gain/loss in a position

Current (spot) exchange rate is $1 = 150 zlotys.

Commerce Bank’s (CB) would lose if long U.S. dollars

the dollar depreciates as indicated by a movement in the exchange rate to $1 = 140 zlotys.

Loss = [1,000 - 250] x [140 - 150] = -7,500 zlotys

CB would gain if the dollar appreciates as indicated by a

exchange rate change to $1 = 160 zlotys.

Example: forward markets

A bank commits to buy 1 million yen, 90 days forward for $9804.

This means that after 90 days, the bank pays $9804 and receives 1 million yen, regardless of movements in exchange rates during the 90-day period.

Forward markets: forward premium.

Forward premium …the forward price of a currency is higher than its spot price, the foreign currency is priced at a premium.

Example: a bank agrees to buy 1 million yen 90 days

forward for 102 yens per dollar. If the spot rate is 105 yens per dollar, the yen

is priced at a forward premium against the dollar.

Forward markets: forward discount.

Forward discount …the forward price of a currency is lower than its spot price, the foreign currency is priced at a discount.

Example: a bank agrees to buy 1 million yen 90 days

forward for 102 yens per dollar.

if the spot rate is 100 yens per dollar, the yen is priced at a forward discount against the dollar.

Relationship between foreign exchange rates and interest rates.

Arbitrage transactions between countries guarantee that interest rate changes produce changes in foreign exchange rates, and vice versa.

If the interest rate differential between securities in two countries falls out of line with the spot-to-forward exchange rate differential, a covered interest arbitrage will take place and investors will make net profits from the series of transactions.

Continuing arbitrage will go on until prices move back into line to eliminate the riskless return from covered interest arbitrage.

Covered interest arbitrage 2. Convert dollars to francs at $1 = 1.7 francs 3. Invest in Swiss securities yielding 10%

000,000,1$0.091

$1,009,000

francs million 1.7(1.7)0.091

$1,090,000

$1,121,776(1.667)

)(1.7)(1.100.091

$1,090,000

francs million 1.87)(1.7)(1.100.091

$1,090,000

1. Borrow dollars at 9% 4. Sell francs for dollars 1 year forward at $1 = 1.667 francs Sample Transaction: Borrow $1,000,000 1. Borrow $1,000,000 at 9%; agree to repay $1,090,000 in one year. 2. Convert $1,000,000 to 1.7 million francs in spot market at $1 = 1.7 francs. 3. Invest 1.7 million francs in 1-year security yielding 10%; will receive 1.87 million francs after 1 year. 4. Sell 1.87 million francs 1 year forward for $1,121,776 at $1 = 1.667 francs. Net profit = $1,121,776 - $1,090,000 = $ 31,776

Foreign exchange rates and interest rates

Covered interest arbitrage …exists when the interest rate differential between securities in two countries is out of line with the spot-to-forward exchange rate differential.

Interest rate parity…exist when covered interest arbitrage profit potential is eliminated.

Interest rate parity implies:

Wherei1: Annual interest rate in Country 1.i2: Annual interest rate in Country 2. s1,2: Spot exchange rate equal to the number of units

of Country 2's currency for one unit of Country 1's currency.

f1,2: One-year forward exchange rate equal to the number of units of Country 2's currency for one unit of Country 1's currency.

1,2

1,21,2

1

12

1,2

1,2

1

2

s

sf

i1

ii

or

1,f

s

i1

i1

The interest rate parity equilibrium condition suggests that:

The forward exchange rate differential, as a fraction of the spot rate, should equal the interest rate differential relative to 1 plus an interest factor to eliminate arbitrage profits.

Example: i1 is 9%,

i2 is 10%, and

s1,2 is 1.7 as in the previous example,

then f1,2 should be equal to 1.7156:

1.7

1.7f

0.091

0.090.10 1,2

Documents

The Effective Use of Capital Chapter 9 Bank Management 6th edition. Timothy W. Koch and S. Scott MacDonald Bank Management, 6th edition. Timothy W. Koch