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Financial Institutions Management: A Risk Management Approach 5th edition Solution Manual - Document preview page 1

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Financial Institutions Management: A Risk Management Approach 5th edition Solution Manual

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Financial Institutions Management: A Risk Management Approach 5th edition Solution Manual - Page 1 preview image1-1Chapter OneWhy Are Financial InstitutionsSpecial?Learning ObjectivesLO1: Discuss the special functions that financial institutions provide.LO2: Illustrate how financial institutions act as brokers and asset transformers.LO3: Explain the types of regulations that are applied to financial institutions as a result of theirspecialness.LO4: Discuss the impact of the financial crisis on financial institutions.LO5: Discuss the actions taken by governments to support the financial system during thefinancial crisis.Chapter OutlineIntroductionFinancial Institutions’ Specialness•FIs Function as Brokers•FIs Function as Asset Transformers•Information Costs•Liquidity and Price Risk•Other Special ServicesOther Aspects of Specialness•The Transmission of Monetary Policy•Credit Allocation•Intergenerational Wealth Transfers or Time Intermediation•Payment Services•Denomination IntermediationSpecialness and Regulation•Safety and Soundness Regulation•Monetary Policy Regulation•Credit Allocation Regulation•Consumer Protection Regulation•Investor Protection Regulation•Entry RegulationThe Changing Dynamics of Specialness•Trends in Canada•Risk Measurement and the Financial Crisis•Global IssuesAppendix1A The Financial Crisis: The Failure of Financial ServicesInstitution Specialness
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Financial Institutions Management: A Risk Management Approach 5th edition Solution Manual - Page 2 preview image
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Financial Institutions Management: A Risk Management Approach 5th edition Solution Manual - Page 3 preview image1-2Internet ExerciseGo to the website of the Office of the Superintendent of Financial Institutions (OSFI) athttp://www.osfi-bsif.gc.ca/and compare the reportsof the different types of FIs that OSFIregulates. Click on “Financial Institutions”to see the drop-down menu. Under the heading,“View Institutions”, click on “Financial Data”.Scroll down and click on “Banks.” Click on“Submit” to download the latest ConsolidatedBalance Sheet. Repeat the process for the otherregulated FIs that are listed.Solutions for End-of-Chapter Questions and Problems: Chapter One1.What arefive risks common toallFIs?Default or credit risk of assets, interest rate risk caused by maturity mismatches between assetsand liabilities, liability withdrawal or liquidity risk, underwritingrisk, and operatingrisks.2.Explain how economic transactions between household savers of funds and corporate usersof funds would occur in a world withoutFIs.In a world without FIs the users of corporate funds in the economy would have todirectlyapproach the household savers of funds in order tosatisfy their borrowing needs.This processwould be extremely costly because of the up-front information costs faced by potential lenders.Cost inefficiencies would arise with the identification of potential borrowers, the pooling ofsmall savings into loans of sufficient size to finance corporate activities, and the assessment ofrisk and investment opportunities.Moreover, lenders would have to monitor the activities ofborrowers over each loan's life span.The net result would be an imperfect allocation of resourcesin an economy.3.Identify and explain three economic disincentives that probably would dampen the flow offunds between household savers of funds and corporate users of funds in an economicworld withoutFIs.Investors generally are averse todirectlypurchasing securities because of (a) monitoring costs,(b) liquidity costs, and (c) price risk.Monitoring the activities of borrowers requires extensivetime, expense, and expertise.As a result, households would prefer to leave this activity to others,and by definition, the resulting lack of monitoring would increase the riskiness of investing incorporate debt and equity markets.The long-term nature of corporate equity and debtsecuritieswould likely eliminate at least a portion of those households willing to lend money, as thepreference of many for near-cash liquidity would dominate the extra returns which may beavailable.Finally, the price risk of transactions on the secondary markets would increase withoutthe information flows and services generated by high volume.4.Identify and explain the two functions in which FIs may specialize thatwouldenable thesmooth flow of funds from household savers to corporate users.
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Financial Institutions Management: A Risk Management Approach 5th edition Solution Manual - Page 4 preview image1-3FIs serveas conduitsbetween users and savers of funds by providing a brokerage function andby engaging inanasset transformation function.The brokerage function can benefit both saversand users of funds and can vary according to the firm. FIs may provide only transaction services,such as discount brokerages, or they also may offer advisory services which help reduceinformation costs, such as full-line firms likeBMO Financial Group.The asset transformationfunction is accomplished by issuing their own securities, such as deposits and insurance policiesthat are more attractive to household savers, and using the proceeds to purchase the primarysecurities of corporations.Thus, FIs take on the costs associated with the purchase of securities.5.In what sense are the financial claims of FIs consideredsecondary securities, while thefinancial claims of commercial corporations are consideredprimary securities?How doesthe transformation process, or intermediation, reduce the risk, or economic disincentives, tothe savers?Funds raised by the financial claims issued by commercial corporations areused to invest in realassets.These financial claims, which are considered primary securities, are purchased by FIswhose financial claims therefore are considered secondary securities.Savers who invest in thefinancial claims of FIs are indirectly investing in the primary securities of commercialcorporations.However, the information gathering and evaluation expenses, monitoring expenses,liquidity costs, and price risk of placing the investments directly with the commercial corporationare reduced because of the efficiencies of the FI.6.Explain howFIsact as delegated monitors.What secondary benefits often accrue to theentire financial system because of this monitoring process?By putting excess funds intoFIs, individual investors give to the FIs the responsibility ofdeciding who should receive the money and of ensuring that the money is utilized properly bythe borrower.In this sense the depositors have delegated the FI to act as a monitor on theirbehalf.Further, the FI can collect information more efficiently than individual investors.The FIcan utilize this information to createnew products, such as businessloans, that continuallyupdate the information pool.This more frequent monitoring process sends importantinformational signals to other participants in the market, a process that reduces informationimperfection and asymmetry between the ultimate sources and users of funds in the economy.7.What are five general areas of FI specialness that are caused by providing various servicesto sectors of the economy?First, FIs collect and process information more efficiently than individual savers. Second, FIsprovide secondary claims to household savers which often have better liquidity characteristicsthan primary securities such as equities and bonds.Third, by diversifying the asset base FIsprovide secondary securities with lower price-risk conditions than primary securities.Fourth, FIsprovide economies of scale in transaction costs because assets are purchased in larger amounts.Finally, FIs provide maturity intermediation to the economy which allows the introduction ofadditional types of investment contracts, such as mortgage loans, that are financed with short-term deposits.
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Financial Institutions Management: A Risk Management Approach 5th edition Solution Manual - Page 5 preview image1-48.What are agency costs?How do FIs solve the information and relatedagency costswhenhousehold savers invest directly in securities issued by corporations?Agency costs occur when owners or managers take actions that are not in the best interests oftheequity investor or lender.These costs typically result from the failure to adequately monitor theactivities of the borrower.If no other lender performs these tasks, the lender is subject to agencycosts as the firm may not satisfy the covenants in the lending agreement. Because the FI investsthe funds of many small savers, the FI has a greater incentive to collect information and monitorthe activities of the borrower.9.How do large FIs solve the problem of high information collection costs forlenders,borrowers, and financial markets?One way financial institutions solve this problem is that they develop secondary securities thatallow for improvements in the monitoring process. An example is the bank loan that is renewedmore quickly than long-term bond debt. The renewal process for loans updates the financial andoperating information of the borrowing firm more frequently, thereby reducing the need forrestrictive bond covenants that may be difficult and costly to implement.10.How do FIs alleviate the problem of liquidity risk faced by investors who wish to invest inthe securities of corporations?Liquidity risk occurs when savers are not able to sell their securities on demand. Banks, forexample, offer deposits that can be withdrawn at any time. Yet,the banks make long-term loansor invest in illiquid assets because they are able to diversify their portfolios and better monitorthe performance of firms that have borrowed or issued securities. Thus,individual investors areable to realize the benefits of investing in primary assets without accepting the liquidity risk ofdirect investment.11.How doFIshelp individual savers diversify their portfolio risks?Which type ofFIis bestable to achieve this goal?Money placed in anyFIwill result in a claim ona more diversified portfolio.Banks lend moneyto many different types of business, consumer, and government customers. Insurance companieshave investments in many different types of assets. Investmentsin a mutual fund may generatethe greatest diversification benefit because of the fund’s investment in a wide array of stocks andfixed income securities.12.How canFIsinvest in high-risk assets with funding provided by low-risk liabilities fromsavers?Diversification of risk occurs with investments in assets that are not perfectly positivelycorrelated.One result of extensive diversification is that the average risk of the asset base of anFI will be less than the average risk of the individual assets in which it has invested.Thus,individual investors realize some of the returns of high-risk assets without accepting thecorresponding risk characteristics.
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Financial Institutions Management: A Risk Management Approach 5th edition Solution Manual - Page 6 preview image1-513.How can individual savers useFIsto reduce the transaction costs of investing in financialassets?By pooling the assets of many small investors, FIs can gain economiesof scale in transactioncosts.This benefit occurs whetherthe FI is lending to a businessor retail customer, orpurchasing assets inthe money and capital markets.In either case, operating activities that aredesigned to deal in large volumes typically are more efficient than those activities designed forsmall volumes.14.What ismaturity intermediation?What are some of the ways in which the risks of maturityintermediation are managed by FIs?If net borrowers and net lenders have different optimal time horizons, FIs can service bothsectors by matching their asset and liability maturities through on-and off-balance sheet hedgingactivities and flexible access to the financial markets.For example, the FI can offer the relativelyshort-term liabilities desired by households and also satisfy the demand for long-term loans suchas home mortgages.By investing in a portfolio of long-and short-term assets that have variable-and fixed-rate components, the FI can reduce maturity risk exposure by utilizing liabilities thathave similar variable-and fixed-rate characteristics, or by using futures, options, swaps, andother derivative products.15.What are five areas of institution-specific FI specialness, and which types of institutions aremost likely to be the service providers?First, commercial banks and other deposit-takinginstitutions are key players for the transmissionof monetary policy from the central bank to the rest of the economy.Second, specific FIs oftenare identified as the major source of finance for certain sectors of the economy.For example,savingsinstitutions(e.g. banks, credit unions, caisses populaires)traditionally serve the creditneeds of the residential real estate market. Third, life insurance and pension funds commonly areencouraged to provide mechanisms to transfer wealth across generations.Fourth, deposit-takinginstitutions efficiently provide payment services to benefit the economy.Finally, mutual fundsprovide denomination intermediation by allowing small investors to purchase pieces of assetswith largeminimum sizes such as t-bills, bonds, and other securities.16.How doDTIssuch asbanks assist in the implementation and transmission of monetarypolicy?The Bank of Canadacandirectlyinvolvebanks in the implementation of monetary policythrough changes in theTarget Overnight Rate.The open market sale and purchase ofGovernment of Canadasecurities by the Bank of Canadainvolves banks in the implementationof monetary policy in a less direct manner.17.What is meant bycredit allocation regulation?What social benefit is this type ofregulation intended to provide?
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Financial Institutions Management: A Risk Management Approach 5th edition Solution Manual - Page 7 preview image1-6Credit allocation regulation refers to the requirement faced by FIs to lend to certain sectors of theeconomy, which are considered to be socially important.These may include housing andfarming. Presumably the provision of credit to make houses more affordable or farms moreviable leads to a more stable and productive society.18.Which intermediaries best fulfill the intergenerational wealth transfer function?What isthis wealth transfer process?Life insurance and pension funds often receive special taxation relief and other subsidies to assistin the transfer of wealth from one generation to another.In effect, the wealth transfer processallowsforthe accumulation of wealth by one generation to be transferred directly to one or moreyounger generations by establishing life insurance policies and trust provisions in pension plans.Often this wealth transfer process avoids the full marginal tax treatment that a direct paymentwould incur.19.What are two of the most important payment services provided byFIs?To what extent dothese services efficiently provide benefits to the economy?The two most important payment services are chequeclearing and wire transfer services.Anybreakdown in these systems would produce gridlock in the payment system with resultingharmful effects to the economy at both the domestic and potentially the international level.20.Whatisdenomination intermediation?How do FIs assist in this process?Denomination intermediation is the process whereby small investors are able to purchase piecesof assets that normally are sold only in large denominations.Individual savers often investsmallamounts in mutual funds.The mutual funds pool these small amounts and purchasea welldiversified portfolio of assets.Therefore,small investors can benefit in the returns and low riskwhich these assets typically offer.21.What isnegative externality? In what ways doesthe existence of negative externalitiesjustify the extra regulatory attention received byFIs?A negative externality refers to the action by one party that has an adverse affect on some thirdparty who is not part of the original transaction.For example, in an industrial setting, smokefrom a factory that lowers surrounding property values may be viewed as a negative externality.For FIs, one concern is the contagion effect that can arise when the failure of one FI can castdoubt on the solvency of other institutions in that industry.22.If financial markets operated perfectly and costlessly, would therebe a need for FIs?To a certain extent, financial intermediation exists because offinancial market imperfections.Ifinformation were available at no costto all participants, savers would not need intermediaries toact as either their brokers or their delegated monitors.However, if there are social benefits tointermediation, such as the transmission of monetary policy or credit allocation, then FIs wouldexist even in the absence of financial market imperfections.
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Financial Institutions Management: A Risk Management Approach 5th edition Solution Manual - Page 8 preview image1-723.Why are FIs among the most regulated sectors in the world?When is net regulatory burdenpositive?FIs are required to enhance the efficient operation of the economy.Successful FIsprovidesources of financing that fund economic growth opportunitiesthat ultimately raise the overalllevel of economic activity.Moreover, successful FIsprovide transaction services to the economythat facilitate trade and wealth accumulation.Conversely, distressed FIs create negative externalities for the entire economy.That is, theadverse impact of an FI failure is greater than just the loss to shareholders and other privateclaimants on the FI's assets.For example, the local market suffers if an FI fails and other FIs alsomay be thrown into financial distress by a contagion effect.Therefore, since some of the costs ofthe failure of an FI are generally borne by society at large, the government intervenes in themanagement of these institutions to protect society's interests.This intervention takes the form ofregulation.However, the need for regulation to minimize social costs mayimpose private costs to the FIsthat would not exist without regulation. This additional private cost is defined as a net regulatoryburden. Examples include the cost of holding excess capital and/or excess liquid assets (e.g.cash)and the extracosts of providing information.Although they may be socially beneficial,these costs add to private operating costs.To the extent that these additional costs help to avoidnegative externalities and to ensure the smooth and efficient operation of the economy, the netregulatory burden is positive.24.What forms of protection and regulation dotheregulators of FIs impose to ensure theirsafety and soundness?Regulators have issued several guidelines to insure the safety and soundness of FIs:a.FIs are required to diversify their assets.For example,federally-regulated FIs mustfollowOSFI’sGuidelines on Large Exposure Limits.b.FIs are required to maintain minimum amounts of capital to cushion any unexpected losses.In the case of banks, OSFI’sstandards require a minimum core and supplementary capitalbased on the size of an FI’srisk-weighted assets.Federally-regulated life insurance andproperty and casualty insurance companies are also required by OSFI to maintain specificminimum capital.c.Regulators have set up guarantees such as the deposit insurance provided by the CanadaDeposit Insurance Corporation (CDIC).d.Regulatorssuch as OSFI and CDICalso engage in periodic monitoring and surveillance,such as on-site examinations, and request periodic information fromFIs.25.How do regulations regarding barriers to entry and the scope of permitted activities affectthecharter valueofFIs?
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Financial Institutions Management: A Risk Management Approach 5th edition Solution Manual - Page 9 preview image1-8The profitability of existing firms will be increased as the direct and indirect costs of establishingcompetition increase.Direct costs include the actual physical and financial costs of establishing abusiness. In the case of FIs, the financial costs include raising the necessary minimumcapital toreceive a charter.Indirect costs include permission from regulatory authorities to receive acharter.As these barriers to entry are stronger, the charter value for existing firms ishigher.26.What six extraordinary actions were taken by central banks and governments during thefinancial crisis? Explain why these actions were necessary.During the financial crisis in 2008, the failure of the investment bank, Lehman Brothers, causedregulators to believe that the major global FIs were too big to fail. The six actions that weretaken by central banks and governments were liquidity injection, by providing additionalfacilities for FIs to borrow from the central bank. The central banks acted as lenders of last resortsince money markets and inter-bank markets were disrupted. Since FIs needed appropriatecollateral to borrow, central banks increased the types of collateral that they would accept. Thisallowed FIs to borrow more which gave them cash to lend to customers. In order to head offbank runs from uninsured depositors, the amount of deposit insurance provided was increased inmany countries (e.g. the U.S.). In some countries, the central banks or governments providedguarantees of all deposits and liabilities (e.g. Ireland) in order to further reduce the potential forruns on the banks. In some cases,governments provided equity capital to FIs (e.g. AIG, the U.S.insurance company) and so became shareholders. As well, governments set up funds to buy toxicassets from FIs in order to clean up their balance sheets and enable them to begin lending again,thus keeping the economy growing.27.What events resulted in banks’ shift from the traditional banking model of “originate andhold” to a model of “originate and distribute?”As FIs adjusted to regulatory changes, one result was a dramatic increase in systemic risk of thefinancial system, caused in large part by a shift in the banking model from that of “originate andhold” to “originate to distribute.” In the traditional model, banks take short term deposits andother sources of funds and use them to fund longer term loans to businesses and consumers.Banks typically hold these loans to maturity, and thus have an incentive to screen and monitorborrower activities even after a loan is made. However, the traditional banking model exposesthe institution to potential liquidity, interest rate, and credit risk. In attempts to avoid these riskexposures and generate improved return-risk tradeoffs, banks shifted to an underwriting model inwhich they originated or warehoused loans, and then quickly sold them. Indeed, most largebanks organized as financial service holding companies to facilitate these new activities.Morerecently activities of shadow banks, nonfinancial service firms that perform banking services,have facilitated the change from the originate and hold model of commercial banking to theoriginate and distribute banking model.These innovations removed risk from the balance sheetof financial institutions and shifted risk off the balance sheet and to other parts of the financialsystem. Since the FIs, acting as underwriters, were not exposed to the credit, liquidity, andinterest rate risks of traditional banking, they had little incentive to screen and monitor activitiesof borrowers to whom they originated loans. Thus, FIs failed to act as specialists in riskmeasurement and management.
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Financial Institutions Management: A Risk Management Approach 5th edition Solution Manual - Page 10 preview image2-1Chapter TwoDeposit-takingInstitutionsLearning ObjectivesLO1: Discuss the size, structure, and composition of the banking industry in Canada.LO2: Discuss the nature and importance of off-balance-sheet assets and liabilities for Canadianbanks.LO3: Explain the types of regulations that are applied to banks in Canada.LO4: Explain how credit unions and caisses populaires differ from banks.Chapter OutlineIntroductionBanks•Size, Structure, and Composition of the Industry•Balance Sheet and Recent Trends•OtherActivities•Regulation•Industry PerformanceCredit Unionsand Caisses Populaires•Size, Structure, and Composition of the Industry and Recent Trends•Balance Sheets•Regulation•Industry PerformanceGlobal Issues: The Financial CrisisAppendix 2A: Financial Statement Analysis Using a Return on Equity (ROE) FrameworkAppendix 2B: Who Regulates Bank Financial Groups in Canada?Appendix 2C:Technology in Commercial BankingINTERNET EXERCISE1.Go to the website of the Office of the Superintendent of Financial Institutions (OSFI)athttp://www.osfi-bsif.gc.ca/andfind the most recent monthly balance sheet for Canadianchartered banks. Click on“Financial Institutions” to see the drop-down menu. Under theheading, “View Institutions”, click on “Financial Data”. Scroll down and click on “Banks.”Click on “Submit” to download the latest Consolidated Balance Sheet.Repeat the process forforeign banks by selecting “Foreign Bank Branches” and select the most recent balance
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Financial Institutions Management: A Risk Management Approach 5th edition Solution Manual - Page 11 preview image2-4sheet. Compare the balance sheet of the domestic banks with that of the foreign banks. Howhave the assets changed from Table 2–4?2.Go to Credit Union Central of Canada’s website athttp://www.cucentral.ca/and downloadthe most recent information on number, assets, and membership in credit unions and caissespopulairesusingthefollowingsteps.Clickon“Policy&Advocacy”andselect“Publications”from the drop down menu. Find and download the pdf fie for the latestSystem Brief that is available to the public. How has the number of CUs and CPs, their size,and membership changed?
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Financial Institutions Management: A Risk Management Approach 5th edition Solution Manual - Page 12 preview image2-3Solutions for End-of-Chapter Questions and Problems: Chapter Two1.What are the differences betweenSchedule I, Schedule II, and Schedule III banks?Schedule I banks aredomestic Canadian banks who are widely-held and chartered in Canadaunder the Bank Act. They are able to offer the full range of services permitted under the BankAct. Schedule II banks are subsidiaries of a foreign bank whoareauthorized to conduct businessunder the Bank Act in Canada. A Schedule III bank is a foreign bank branch that is authorized toaccept deposits in excess of $150,000under the Bank Act. All banks in Canada are regulated bythe Office of the Superintendent of Financial Services (OSFI).2.Whatchanges have banks implemented to deal with changes in the financial servicesenvironment?Corporations have utilized the commercial paper markets with increased frequency rather thanborrow from banks. In addition, many banks have sold loan packages directly into the capitalmarkets (securitization) as a method to reduce balance sheet risks and to improve liquidity.Finally, the decrease in loan volume during the early 1990s and early 2000s was due in part tothe recession in the economy.Further, as deregulation of the financial services industry occurredduring the 1990s, the positionof banks as the primary financialservices providereroded. North American banks of all sizesincreased the use of off-balance sheet activities in an effort to generate additional fee income.Letters of credit, futures, options, swaps and other derivative products are not reflected on thebalance sheet, but do provide fee income for the banks.3.What are the major uses of funds for banks in Canada? What are the primary risks to thebank caused by each use of funds? Which of the risks is most critical to the continuingoperation of a bank?Loansand investment securities arethe primary assets of the banking industry. Non-mortgageloans are relatively more important.Mortgage loans are alsoa large part of the banks’ assets.Each of these types of loans creates credit, and to varying extents, liquidity risks for the banks.The security portfolio normally is a source of liquidity and interest rate risk, especially with theincreased use of various types of mortgage backed securities and structured notes. In certainenvironments, each of these risks can create operational and performance problems for a bank.4.What are the major sources of funds for banks in Canada? How is the landscape for thesefunds changing and why?The primary sources of funds are deposits. The amount ofretail (consumer)demand depositsdeclines when smallinvestorslook for higher returns and movetheir funds into fixed termdeposits and other higher yielding investmentssuch as mutual funds.In general, a significantportion of consumer demand deposits are core funding for Canadian banks. The banks alsopurchase wholesale funds such as corporate deposits and interbank deposits. Short-term
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Financial Institutions Management: A Risk Management Approach 5th edition Solution Manual - Page 13 preview image2-4liabilities other than deposits may decline as banks institute the liquidity requirements of BaselIII (see Chapters 12 and 20).5.How does the liability maturity structure of a bank’s balance sheet compare with thematurity structure of the asset portfolio? What risks are created or intensified by thesedifferences?Deposit and non-deposit liabilities tend to have shorter maturities than assets such as loans. Thematurity mismatch creates varying degrees of interest rate risk and liquidity risk.6.What types of activities normally are classified as OBSactivities?Off-balance-sheet activities include the issuance of guarantees that may be called into play at afuture time, and the commitment to lend at a future time if the borrower desires.a.How does an OBS activity move onto the balance sheet as an asset or liability?The activity becomes an asset or a liability upon the occurrence of a contingent event,which may not be in the control of the bank. In most cases the other party involved withthe original agreement will call upon the bank to honour its original commitmentsuch as aloan commitment or a letter of credit.b.What are the benefits of OBS activities to a bank?The initial benefit is the fee that the bank charges when making the commitment. If thebank is required to honour the commitment, the normal interest rate structure will apply tothe commitment as it moves onto the balance sheet. Since the initial commitment does notappear on the balance sheet, the bank avoids the need to fund the asset with either depositsor equity. Thus thebank avoids possible additionaldeposit insurance premiums whileimproving the earnings stream of the bank.c.What are the risks of OBS activities to a bank?The primary risk to OBS activities on the asset side of the bank involves the credit risk ofthe borrower. In many cases the borrower will not utilize the commitment of the bank untilthe borrower faces a financial problem that may alter the creditworthiness of the borrower.Moving the OBS activity to the balance sheet may have an additional impact on the interestrate and foreign exchange risk of the bank, and as well, may pose a liquidity risk if the FIhas difficulty making the funds available to the borrower.Further, at the heart of thefinancial crisis were losses associated with off-balance-sheet mortgage-backed securitiescreated and held by FIs. Losses resulted in failure, acquisition, or bailout of some of thelargest global FIs and a near meltdown of the world’s financial and economic systems.7.Howismobileand onlinebanking expected to provide benefits in the future?
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Financial Institutions Management: A Risk Management Approach 5th edition Solution Manual - Page 14 preview image2-5The extent of the impact ofmobileand onlinebanking remains unknown. However, theexistence of new technology allowsbanks to open markets andtodevelop products that did notexist prior to the Internet. Efforts have focused onthe retail customerand businesscustomersand have changed cash management for both. The trend should continue with the advent offaster, more customer friendly products and services, and the continued technology education ofcustomers.8.What factors are given credit for the strong performance banks in the early 2000s?The lowest interest rates in many decades helped bank performance on both sides of the balancesheet. On the asset side, many consumersrefinancedhomes and purchasednew homes, anactivity that caused fee income from mortgage lending to increase and remain strong.Meanwhile, the rates banks paid on deposits shrank to all-time lows. Inaddition, thedevelopment anduse of new financial instruments such as credit derivatives and mortgagebacked securities helped banks movecredit risk off theirbalance sheets. Finally, informationtechnologyhelped banks manage their risk more efficientlythrough better and quicker access tofinancial markets.9.How does theasset structure of CUscompare with the asset structure of banks?The relative proportionsof credit union assets are similar tobankswith loansand mortgagesrepresenting the major portion of assets.However, nonmortgage loans of credit unions arepredominantly consumer loans. On the liability side of the balance sheet, credit unions differfrom banks in that theyhave less reliance on large term deposits, and have only a small amountof debtfrom any source. The primary sources of funds for credit unions are small term depositsand chequingand savings accounts.10.Compare and contrast the performance of Canadian DTIswith U.S. and global FIsduringand after the financial crisis.Quickly after it hit the U.S., the financial crisis spread worldwide. As the crisis started, banksworldwide sawlosses driven by their portfolios of structured finance products and securitizedexposures to the subprime mortgage market. Losses were magnified by illiquidity in the markets forthose instruments. As with U.S. banks, this led to substantial losses in their marked to marketvaluations. In Europe, the general picture of bank performance in 2008 was similar to that in theU.S. That is, net income fell sharply at all banks. The largest banks in the Netherlands, Switzerlandand the United Kingdom had net losses for the year. Banks in Ireland, Spain and the UnitedKingdom were especially hard hit as they had large investments in mortgages and mortgage-backedsecurities. Because they focused on the domestic retail banking, French and Italian banks were lessaffected by losses on mortgage-backed securities. Continental European banks, in contrast to UKbanks, partially cushioned losses through an increase in their net interest margins.A number of European banks averted outright bankruptcy thanks to direct support from thecentral banks and national governments.During the last week of September and first week ofOctober 2008, the German government guaranteed all consumer bank deposits and arranged abailout of Hypo Real Estate, the country’s second largest commercial property lender. TheUnited Kingdom nationalized mortgage lender Bradford & Bingley (the country’s eighth largest
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Financial Institutions Management: A Risk Management Approach 5th edition Solution Manual - Page 15 preview image2-4mortgage lender) andraised deposit guaranteesper account. Ireland guaranteed deposits and debtof its six major financial institutions. Iceland rescued its thirdlargest bank by purchasing75percent of the bank’s stock and a few days later seized the country’s entire banking system. TheNetherlands’, Belgium’s, and Luxembourg’scentral governments together agreed to injectUS$16.37 billion into Fortis NV (Europe’s first ever cross-border financial services company) tokeep it afloat. However, five days later this deal fell apart, and the bank was split up. The Dutchbought all assets located in the Netherlands for approximatelyUS$23 billion.The central bank inIndia stepped in to stop a run on the country’s second largest bank ICICI Bank, by promising topump in cash. Central banks in Asia injected cash into their banking systems as banks’reluctance to lend to each other led the Hong Kong Monetary Authority to inject liquidity into itsbanking system after rumours led to a run on Bank of East Asia Ltd. South Korean authoritiesoffered loans and debt guarantees to help small and midsize businesses with short term funding.The United Kingdom, Belgium, Canada, Italy, and Ireland were just a few of the countries topass an economic stimulus plan and/or bank bailout plan. The Bank of England lowered its targetinterest rate to a record low of 1 percent hoping to help the British economy out of a recession.The Bank of Canada, Bank of Japan, and Swiss National Bank also lowered their main interestrate to 1 percent or below. All of these actions were a result of the spread of the U.S. financialmarket crisis to world financial markets.The worldwide economic slowdown experienced in the later stages of the crisis meant thatbank losses became more closely connected to macroeconomic performance.Countries across theworld saw companies scrambling for credit and cutting their growth plans. Additionally,consumers worldwide reduced their spending. Even China’s booming economy slowed faster thanhad been predicted, from 10.1 percent in the second quarter of 2008 to 9 percent in the thirdquarter. This was the first time since 2002 that China’s growth was below 10 percent and dimmedhopes that Chinese demand could help keep world economies going. In late October, the globalcrisis hit the Persian Gulf as Kuwait’s central bank intervened to rescue Gulf Bank, the first bankrescue in the oil rich Gulf. Until this time, the area had been relatively immune to the worldfinancial crisis. However, plummeting oil prices (which had dropped over 50 percent between Julyand October) left the area’s economies vulnerable.In this period, the majority of bank losses weremore directly linked to a surge in borrower defaults and to anticipated defaults as evidenced by theincrease in the amount and relative importance of loan loss provision expenses.International banks’ balance sheets continued to shrink during the first half of 2009 (although ata much slower pace than in the preceding six months) and, as in the U.S., began to recover in thelatter half of the year. In the fall of 2009, a steady stream of mostly positive macroeconomicnews reassured investors that the global economy had turned around, but investor confidenceremained fragile. For example, in late November 2009, security prices worldwide droppedsharply as investors reacted to news that government-owned Dubai World had asked for a delayin some payments on its debt. Further, throughout the spring of 2010 Greece struggled with asevere debt crisis. Early on, some of the healthier European countries tried to step in and assistthe debt ridden country. Specifically, in March 2010 a plan led by Germany and France to bailout Greece with as much asUS$41 billion in aid began to take shape. However, in late AprilGreek bond prices dropped dramatically as traders began betting a debt default was inevitable,even if the country received a massive bailout. The selloff was the result of still more bad newsfor Greece, which showed that the 2009 budget deficit was worse than had been previouslyreported, and as a result politicians in Germany began to voice opposition to a Greek bailout.Further, Moody’s Investors Service downgraded Greece’s debt rating and warned that additional
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Financial Institutions Management: A Risk Management Approach 5th edition Solution Manual - Page 16 preview image2-7cuts could be on the way.Greece’s debt created heavy losses across the Greek banking sector. Arun onGreek banks ensued. Initially,between €100 and €500 million per day was beingwithdrawn from Greek banks. At its peak, the run on Greek banks produced deposit withdrawalsof as high as €750 billion a day, nearly 0.5 percent of the entire €170 billion deposit base in theGreek banking system.Problemsin the Greek banking system then spread to other European nations with fiscalproblems, such as Portugal, Spain, and Italy.The risk of a full blown banking crisis arose inSpain where the debt rating of 16 banks and four regions were downgraded by Moody’s InvestorService.Throughout Europe, some of the biggest banks announced billions of euros lost fromwrite downs on Greek loans. In 2011,Crédit Agricolereported a record quarterly net loss of€3.07 billion ($4.06 billion U.S.) after a €220 million charge on its Greek debt. Great Britain’sRoyal Bank of Scotlandrevalued its Greek bonds at a 79 percent loss—or £1.1 billion ($1.7billion U.S.)—for 2011. Germany’s Commerzbank’s fourth quarter 2011 earnings decreased by a€700 million due to losses on Greek sovereign debt. The bank needed to find €5.3 billion eurosto meet the stricter new capital requirements set by Europe’s banking regulator. Bailed outFranco-Belgian bankDexiawarned it risked going out of business due to losses of €11.6 billionfrom its break-up and exposure to Greek debt and other toxic assets such as U.S. mortgage-backed securities. Even U.S. banks were affected by the European crisis.In late 2010, U.S. bankshad sovereign risk exposure to Greece totaling $43.1 billion. In addition, exposures to Irelandtotaled $113.9 billion, to Portugal totaled $47.1 billion, and to Spain $187.5 billion. Worldwide,bank exposure to these four countries totaled $2,512.3 billion. Default byasmall country likeGreece cascaded into something that threatened the world’s financial system.Worried about the effect a Greek debt crisis might have on the European Union, otherEuropean countries tried to step in and assist Greece. On May 9, 2010,in return for huge budgetcuts,Europe's finance ministers and the International Monetary Fund approved a rescue packageworth $147 billion and a “safety net” of $1 trillion aimed at ensuring financial stability acrossEurope. Through the rest of 2010 and into 2012, Eurozone leaders agreed on more measuresdesigned to prevent the collapse of Greece and other member economies. In return, Greececontinued to offer additional austerity reforms and agreed to reduce its budget deficits. At times,the extent of these reforms and budget cuts led to worker strikes and protests (some of whichturned violent), as well as changes in Greek political leadership. In December 2011,the leadersof France and Germany agreed on a new fiscal pact that they said would help prevent anotherdebt crisis. Then French President Nicolas Sarkozy outlined the basic elements of the plan toincrease budget discipline after meeting with German Chancellor Angela Merkel in Paris. Thepact, which involved amending or rewriting the treaties that govern the European Union, waspresented in detail at a meeting of European leaders and approved. Efforts by the EU andreforms enacted by the Greek and other European country governments appear to have worked.As on December 18, 2012, Standard & Poor's raised its rating on Greek debt by six notches to Bminus from selective default Tuesday. S&P cited a strong and clear commitment from membersof the euro zone to keep Greece in the common currency bloc as the main reason for the upgrade.In contrast to the global impacts above, the major disruption in Canada came from the freezingof the non-bank sponsored asset-backed commercial paper market (See Chapter 26 for details).Approximately $35 billion of ABCP was unable to be rolled over in 2008 and the issue was notresolved until 2010. No banks failed in Canada as a result of the global liquidity and credit crisis.
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